The fourteenth edition of Purchasing and Supply Management focuses on
decision making throughout the supply chain. Based on the conviction that
supply managers, in concert with suppliers and distributors, have to contribute
to organizational goals and strategies, this edition continues to focus on how
to make that mission a reality.
Fourteenth
Edition
Highlights of the Fourteenth Edition:
More than 40 real-life supply chain cases afford the opportunity to apply
of the acquisition process.
Criteria for supply decisions have been organized into three categories:
(1) strategic, (2) operational, and (3) additional. In this third category,
new factors such as balance sheet and income statement considerations,
dimensions of risk, and environmental and social considerations are
considered.
Visit the text’s Online Learning Center at www.mhhe.com/Johnson14e
Michiel R. Leenders, D.B.A., PMAC Fellow
Professor of Purchasing Management Emeritus
Richard Ivey School of Business
The University of Western Ontario
Anna E. Flynn, Ph.D., C.P.M.
Formerly Clinical Associate Professor Supply Chain Management
Thunderbird School of Global Management
Formerly Associate Professor
Institute for Supply Management
TM
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Flynn
Purchasing and
Supply Management
Johnson
Leenders
Flynn
MD DALIM #1093963 06/05/10 BLUE GREEN
P. Fraser Johnson, Ph.D.
Leenders Purchasing Management Association of Canada Chair
Associate Professor, Operations Management
Richard Ivey School of Business
The University of Western Ontario
Purchasing and
Supply Management
company issues and opportunities.
Fourteenth Edition
Purchasing
and Supply
Management
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The McGraw-Hill/Irwin Series Operations and Decision Sciences
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Purchasing and Supply Chain
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Purchasing and
Supply Management
Fourteenth Edition
P. Fraser Johnson, PhD
Leenders Purchasing Management
Association of Canada Chair
Associate Professor, Operations
Management
Richard Ivey School of Business
The University of Western Ontario
Michiel R. Leenders, DBA, PMAC
Fellow
Professor of Purchasing Management
Emeritus
Richard Ivey School of Business
The University of Western Ontario
Anna E. Flynn, PhD
Formerly Clinical Associate Professor
Supply Chain Management
Thunderbird School of Global
Management
Formerly Associate Professor
Institute for Supply Management
joh77899_fm_i-xviii.indd iii
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PURCHASING AND SUPPLY MANAGEMENT, FOURTEENTH EDITION
Published by McGraw-Hill, a business unit of The McGraw-Hill Companies, Inc., 1221
Avenue of the Americas, New York, NY 10020. Copyright © 2011 by The McGraw-Hill Companies, Inc.
All rights reserved. Previous editions © 2006, 2002, and 1997. No part of this publication may be reproduced or
distributed in any form or by any means, or stored in a database or retrieval system, without the prior written
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Some ancillaries, including electronic and print components, may not be available to customers outside the
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This book is printed on acid-free paper.
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All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.
Library of Congress Cataloging-in-Publication Data
Johnson, P. Fraser.
Purchasing and supply management / P. Fraser Johnson, Michiel R. Leenders, Anna E. Flynn.—14th ed.
p. cm.
Rev. ed. of: Purchasing and supply management / Michiel R. Leenders . . . [et al.]. 13th ed. 2006.
ISBN 978-0-07-337789-6 (alk. paper)
1. Industrial procurement. 2. Materials management. I. Leenders, Michiel R. II. Flynn, Anna E.
III. Purchasing and supply management. IV. Title.
HD39.5.L43 2010
658.7—dc22
2010015574
www.mhhe.com
joh77899_fm_i-xviii.indd iv
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About the Authors
P. Fraser Johnson is the Leenders Purchasing Management Association of Canada Chair
at the Richard Ivey School of Business, The University of Western Ontario. Professor
Johnson is also the Director of the Ivey MBA Program. He earned a PhD from Ivey
in 1995, specializing in Operations Management and, following graduation, joined the
faculty of Commerce & Business Administration at the University of British Columbia.
Fraser returned to Ivey as a faculty member in 1998 and has taught courses in purchasing
and supply, logistics, and operations. Prior to accepting a faculty position, Fraser worked
in the automotive parts industry where he held a number of senior management positions
in both finance and operations. His experience includes managing automotive manufacturing facilities in Canada and the United States, and overseeing a joint venture partnership
in Mexico. Professor Johnson is an active researcher in the area of purchasing and supply
chain management, and he is the author of several articles that have been published in a
wide variety of magazines and journals. Fraser has also authored a number of teaching
cases. He currently is an associate editor for the Journal of Supply Chain Management and
sits on the editorial review board for the Journal of Purchasing and Supply Management.
Professor Johnson has consulted for organizations in the private and public sectors and has
taught in a number of different management development programs in the United States,
Canada, and Europe.
Michiel R. Leenders is professor emeritus at the Richard Ivey School of Business at
the University of Western Ontario. He received a degree in mining engineering from the
University of Alberta, an MBA from the University of Western Ontario, and his doctorate from the Harvard Business School. Mike has written a large number of articles in a
variety of magazines and journals. His texts have been translated into 10 different languages and include Value-Driven Purchasing: The Key Steps in the Acquisition Process
(with Anna E. Flynn), published by Irwin Professional Publishing; Reverse Marketing,
The New Buyer-Supplier Relationship (with David Blenkhorn), published by the Free
Press; Improving Purchasing Effectiveness through Supplier Development, published
by the Harvard Division of Research; Learning with Cases, Writing Cases, and Teaching with Cases with James A. Erskine and Louise Mauffette-Leenders, published by the
Richard Ivey School of Business. He has also co-authored 10 editions of Purchasing and
Supply Management, published by McGraw-Hill-Irwin. Mike has taught and consulted
extensively both in Canada and internationally. He was the educational advisor to the
Purchasing Management Association of Canada from 1961–1994. He received PMAC’s
Fellowship Award in 1975, the PMAC Chair from 1993 to 2009, the Financial Post
Leaders in Management Education Award in 1997, and the Hans Ovelgonne Purchasing
Research Award in 2001. He is the director of the Ivey Purchasing Managers Index and a
director of ING Bank of Canada.
Anna E. Flynn teaches executive and management programs in purchasing and supply
management for organizations in the North America, Europe, and Asia. She is a former faculty member at Thunderbird School of Global Management and Arizona State
University, where she was also director of the undergraduate program in supply chain
v
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vi About the Authors
management. She also served as vice president and associate professor at the Institute for
Supply Management (ISM), where she developed and taught two- to five-day seminars
in the United States, Canada, Mexico, the Caribbean, Hong Kong, and Lisbon. She has
worked as a research associate for CAPS Research, a global network of executives and
academics focused on strategic supply management knowledge and practice. Anna is author
of Leadership of Supply Management (2008); co-editor (with Cavinato and Kauffman) of
The Supply Management Handbook and author of Chapter 7, “Knowledge-Based Supply
Management” (McGraw-Hill, 2006); co-author (with Farney, 2000) of the NAPM Supply
Management Knowledge Series, Volume IV: The Supply Management Leadership Process;
and co-author (with Leenders, 1994) of Value-Driven Purchasing: Managing the Key
Steps in the Acquisition Process. She earned a bachelor’s degree in international studies
from the University of Notre Dame, an MBA from Arizona State University, and a PhD
from Arizona State University.
joh77899_fm_i-xviii.indd vi
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Preface
Purchasing and supply management has become increasingly visible in a world where
supply is a major determinant of corporate survival and success. Supply chain performance influences not only operational and financial risks but also reputational risk.
Extending the supply chain globally into developing countries places new responsibilities
on supplier and supply, not only to monitor environmental, social, political, and security
concerns but also to influence them. Thus, the job of the supply manager of today goes
way beyond the scope of supply chain efficiency and value for money spent to search for
competitive advantage in the supply chain. Cost containment and improvement represent
one challenge; the other is revenue enhancement. Not only must the supply group contribute directly to both the balance sheet and the income statement; it must also enhance
the performance of other members of the corporate team. Superior internal relationship
and knowledge management need to be matched on the exterior in the supply network to
assure that the future operational and strategic needs of the organization will be met by
future markets. The joy of purchasing and supply management lives in the magnitude of
its challenges and the opportunities to achieve magnificent contributions.
For more than 80 years this text and its predecessors have championed the purchasing
and supply management cause. Based on the conviction that supply and suppliers have
to contribute effectively to organizational goals and strategies, this and previous editions
have focused on how to make that mission a reality.
Thus, the examples in the text and more than 40 real-life supply chain cases afford the
chance to apply the latest research and theoretical developments in the field to real-life
issues, opportunities, decisions, and problems faced by practitioners. Continuing advances
in MIS and technology provide new ways to improve supply efficiency and effectiveness.
New security, environmental, and transparency requirements and the search for meaningful supply metrics have further complicated the challenges faced by supply managers all
over the world.
In this edition the focus on decision making in the supply chain has been strengthened
considerably. Also the chapter sequence has been adjusted accordingly to reflect the
chronological order of the acquisition process. Criteria for supply decisions have been
identified in three categories: (1) strategic, (2) operational, and (3) additional. It is the
third category with balance sheet and income statement considerations, all dimensions of
risk, environmental, and social considerations that is growing in relevance, making sound
supply decisions an even more complex challenge.
Since the sixth edition of this text over 30 years ago, Harold E. Fearon has been an
author of this text. As the founder of the supply chain group at Arizona State University,
the first editor of the International Journal of Supply Chain Management and the conceptualizer and first director of CAPS Research, Hal Fearon has been one of the true trailblazers of our field for decades. In this edition, Hal has no longer participated, although his
past contributions are still evident throughout this text.
A second change in authorship for this edition has switched the roles of Michiel
R. Leenders, listed as the first author of six previous editions, and P. Fraser Johnson, who
has taken over the Leenders PMAC Chair of Purchasing Management at the Richard Ivey
School of Business. Anna Flynn continues as a valuable member of the author team.
vii
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viii Preface
A book with text and cases depends on many to contribute through their research and
writing to expand the body of knowledge of the field. Thus, to our academic colleagues
our thanks for pushing out the theoretical boundaries of supply management. For their
specific suggestions regarding the manuscript, our appreciation goes to Casey Kleindienst,
California State University—Fullerton; William Magrogan, University of Maryland—
University College; Jayanth Jayaram, University of South Carolina; and John Hanson,
University of San Diego, all of whom provided detailed reviews and offered numerous
suggestions for improving the presentation. To many practitioners, we wish to extend our
gratitude for proving what works and what does not and providing their stories in the cases
in this text. Also many case writers contributed their efforts so that about half of all the
cases in this edition are new.
Case contributors in alphabetical order included: Collin Ashton, Louis Beaubien,
Larry Berglund, Jorge Colazo, Nancy Dai, Niki da Silva, Dev K. Dutta, Tony Francolini,
Manish Kumar, Matthew D. Lynall, Louise Mauffette-Leenders, Leane Morfopoulos,
Elizabeth O’Neil, Peruvemba Sundaram Ravi, Suhaib Riaz, Frank Tang, Rob Turner,
Dave Vannette, Asad Wali, and Marsha Watson.
The production side of any text is more complicated than most authors care to admit. The
original manuscript preparation largely fell to Elaine Carson, who was obviously not scared
off during the previous editions. At McGraw Hill/Irwin, Rebecca Mann, Dick Hercher, Lee
Stone, and many others contributed to turn our efforts into a presentable text.
Kathleen Little, CPM, ably indexed this text and many previous editions.
The support of Dean Carol Stephenson and our colleagues at the Richard Ivey School
of Business has been most welcome.
The assistance of the Institute for Supply Management in supporting the continuous
improvement of supply education is also very much appreciated.
P. Fraser Johnson
Michiel R. Leenders
Anna E. Flynn
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Brief Contents
About the Authors v
10 Price
Preface vii
11 Cost Management
288
12 Supplier Selection
313
1
Purchasing and Supply
Management 1
253
13 Supplier Evaluation and Supplier
Relations 352
2
Supply Strategy
3
Supply Organization
4
Supply Processes and Technology
5
Make or Buy, Insourcing, and
Outsourcing 120
26
14 Global Supply Management
45
6
Need Identification and
Specification 135
7
Quality
8
Quantity and Inventory
9
Delivery
76
15 Legal and Ethics
383
417
16 Other Supply Responsibilities
463
17 Supply Function Evaluation and
Trends 481
INDEXES
165
Case Index
198
513
Subject Index
514
231
ix
joh77899_fm_i-xviii.indd ix
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Table of Contents
About the Authors
v
Risk Management
Preface vii
Chapter 1
Purchasing and Supply Management
Purchasing and Supply Management
Supply Management Terminology
Supply and Logistics 5
1
Strategic Components
3
4
The Size of the Organization’s Spend and Financial
Significance 6
Supply Contribution 8
The Operational versus Strategic Contribution of
Supply 8
The Direct and Indirect Contribution of Supply 9
The Nature of the Organization 13
Supply Qualifications and Associations
Challenges Ahead 18
16
Supply Chain Management 18
Measurement 19
Risk Management 19
Sustainability 19
Growth and Influence 19
Effective Contribution to Organizational Success 20
The Organization of This Text 20
Conclusion 21
Questions for Review and Discussion
References 21
Cases 22
1–1 Qmont Mining 22
1–2 Erica Carson 23
1–3 Southeastern University
Chapter 2
Supply Strategy
30
Operational Risk: Supply Interruptions and Delays 30
Financial Risk: Changes in Price 31
Reputational Risk 31
Managing Supply Risks 31
The Corporate Context 32
21
24
26
Levels of Strategic Planning 27
Major Challenges in Setting Supply Objectives and
Strategies 29
Strategic Planning in Supply Management 29
33
What? 33
Quality? 34
How Much? 35
Who? 36
When? 36
What Price? 36
Where? 36
How? 36
Why? 37
Conclusion 37
Questions for Review and Discussion
References 38
Cases 39
37
2–1 Spartan Heat Exchangers Inc. 39
2–2 Sabor Inc. 40
2–3 Ford Motor Company: Aligned Business
Framework 42
Chapter 3
Supply Organization
45
Objectives of Supply Management 47
Organizational Structures for Supply
Management 50
Small and Medium-Sized Organizations 50
Large Organizations 51
Centralized and Decentralized Supply Structures 52
Hybrid Supply Structure 52
Specialization within the Supply Function 53
Structure for Direct and Indirect Spend 56
Managing Organizational Change in Supply 57
Organizing the Supply Group
58
The Chief Purchasing Officer (CPO)
Reporting Relationship 60
58
x
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Table of Contents
Supply Activities and Responsibilities
61
9. Maintenance of Records and
Relationships 92
What Is Acquired 61
Supply Chain Activities 61
Type of Involvement 63
Involvement in Corporate Activities 63
Influence of the Industry Sector on Supply
Activities 63
Supply Teams
Linking Data to Decisions 93
Manage Supplier Relationships
A Supply Process Flowchart
Strategic Spend 95
Nonstrategic Spend 95
Leading and Managing Teams 64
Cross-Functional Supply Teams 64
Other Types of Supply Teams 66
Benefits of Information Systems Technology
Technology Options 99
Types of Information Systems 100
Intranets and Extranets 102
69
78
1. Recognition of Need 80
2. Description of Need 81
Purposes and Flow of a Requisition 81
Types of Requisitions 82
Early Supply and Supplier Involvement 83
84
84
4. Supplier Selection and Determination
of Terms 85
5. Preparation and Placement of the
Purchase Order 85
6. Follow-up and Expediting 88
Assess Costs and Benefits
7. Receipt and Inspection
89
90
Eliminate or Reduce Inspection
8. Invoice Clearing and Payment
90
90
Aligning Supply and Accounts Payable 91
Cash Discounts and Late Invoices 92
joh77899_fm_i-xviii.indd xi
76
Electronic Procurement Systems 103
Electronic or Online Catalogs 105
Electronic Data Interchange (EDI) 105
E-Marketplaces 106
Online Reverse Auctions 107
Radio Frequency Identification (RFID) 109
Implications for Supply 109
Policy and Procedure Manual 111
Conclusion 111
Questions for Review and Discussion
References 112
Cases 113
Strategy and Goal Alignment 78
Ensuring Process Compliance 79
Information Flows 80
Steps in the Supply Process 80
Issue an RFx
98
99
Technology-Driven Efficiency and
Effectiveness 102
Chapter 4
Supply Processes and Technology
3. Identification of Potential Sources
94
Information Systems and the Supply Process
3–1 Iowa Elevators 70
3–2 Roger Haskett 73
The Supply Management Process
93
Improving Process Efficiency and
Effectiveness 93
64
Consortia 67
Conclusion 69
Questions for Review and Discussion
References 69
Cases 70
xi
4–1 Bright Technology International
4–2 Hemingway College 115
4–3 Portland Bus Company 116
112
113
Chapter 5
Make or Buy, Insourcing, and
Outsourcing 120
Make or Buy
121
Reasons for Make instead of Buy 123
Reasons for Buying Outside 123
The Gray Zone in Make or Buy 124
Subcontracting 125
Insourcing and Outsourcing 126
Insourcing 126
Outsourcing 127
Outsourcing Supply and Logistics 129
11/06/10 2:12 PM
xii Table of Contents
Supply’s Role in Insourcing and Outsourcing
Conclusion 130
Questions for Review and Discussion 130
References 130
Cases 131
5–1 B&L Inc. 131
5–2 Rondot Automotive 132
5–3 Alicia Wong 133
136
1. Strategic Criteria 136
2. Traditional Criteria 137
3. Additional Current Criteria 138
Categories of Needs
140
1. Resale 141
2. Raw and Semiprocessed Materials 141
3. Parts, Components, and Packaging 141
4. Maintenance, Repair, and Operating
Supplies 142
5. Capital 142
6. Services 145
7. Other 147
Repetitive or Nonrepetitive
Requirements? 147
Commercial Equivalents 148
Early Supply and Supplier
Involvement 149
Methods of Description 149
Brand 150
“Or Equal” 150
Specification 150
Miscellaneous Methods of Description 152
Combination of Descriptive Methods 153
Sources of Specification Data 153
Standardization and Simplification 154
Conclusion 155
Questions for Review and Discussion 155
References 156
Cases 156
6–1 Moren Corporation (A) 156
6–2 Moren Corporation (B) 158
6–3 Carson Manor 160
joh77899_fm_i-xviii.indd xii
Chapter 7
Quality 165
Role of Quality in Supply
Management 166
Defining Quality 168
Quality 168
Function 168
Suitability 168
Reliability 168
Quality Dimensions 169
“Best Buy” 169
Determining the “Best Buy” 170
Chapter 6
Need Identification and
Specification 135
Need Criteria in the Value Proposition
129
The Cost of Quality
170
Prevention Costs 172
Appraisal Costs 172
Internal Failure Costs 172
External Failure Costs 172
Morale Costs 173
An Overall Quality–Cost Perspective 173
Quality Management Tools and
Techniques 173
Total Quality Management (TQM) 173
Continuous Improvement 175
Quality Function Deployment (QFD) 175
Six Sigma 176
Statistical Process Control (SPC) 177
Sampling, Inspection, and Testing 180
The Quality Assurance and Quality Control
Group 184
Assuring the Quality of Purchased
Services 185
Supplier Certification 189
Quality Standards and Awards
Programs 190
ISO 9000 Quality Standards 190
ISO 14000 Environmental Standards 191
The Malcolm Baldrige National (U.S.) Quality
Award 192
The Deming Prize 192
Conclusion 192
Questions for Review and Discussion
References 193
Cases 194
193
7–1 The Power Line Poles 194
7–2 Air Quality Systems, Inc. 196
6/9/10 10:05 PM
Table of Contents xiii
Chapter 8
Quantity and Inventory
Quantity and Timing Issues
Cases 227
8–1 Sedgman Steel 227
8–2 Throsel-Teskey Drilling 228
198
199
Quantity and Delivery 200
Time-Based Strategies 200
Forecasting
Chapter 9
Delivery 231
201
Logistics
Forecasting Techniques 202
Collaborative Planning, Forecasting, and
Replenishment (CPFR) 203
Determining Order Quantities and Inventory
Levels 203
Fixed-Quantity Models 203
Fixed-Period Models 205
Probabilistic Models and Service
Coverage 205
Buffer or Safety Stocks and Service Levels 206
Planning Requirements and Resources
208
Material Requirements Planning (MRP) 208
Capacity Requirements Planning (CRP) 209
Manufacturing Resource Planning
(MRP II) 209
Enterprise Resource Planning (ERP)
Systems 210
Supply Implications of MRP 210
Functions and Forms of Inventories
211
215
Costs of Inventories 215
ABC Classification 217
Vendor- or Supplier-Managed Inventory
(VMI/SMI) 219
Lean Supply, Just-in-Time (JIT), and Kanban
Systems 219
Managing Supply Chain Inventories 223
Determing Quantity of Services
233
Transportation Regulation and
Deregulation 234
Supply’s Involvement in Transportation
Transportation Modes and Carriers
Conclusion 226
Questions for Review and Discussion
References 227
235
235
Road 236
Rail and Intermodal 236
Pipelines 236
Air 236
Water 237
Radio Frequency Waves 237
Types of Carriers, Providers, and Service
Options 237
Types of Carriers 238
Transportation Service Providers 238
Specialized Service Options 238
239
“Best Value” Delivery Decisions 239
Key Selection Criteria 240
FOB Terms and Incoterms 241
Rates and Pricing 242
Documentation in Freight Shipments 243
Expediting and Tracing Shipments 245
Freight Audits 245
Delivery Options for Services
245
Buyer Location versus Supplier Location 246
On-premise versus Off-premise/Web-based IT
Delivery 247
Transportation and Logistics Strategy 247
Organization for Logistics 248
Conclusion 249
Questions for Review and Discussion 249
References 249
Cases 250
224
Aggregating Demand 224
Managing Consumption 224
Dimensions of Services and Quantity
Decisions 224
joh77899_fm_i-xviii.indd xiii
Transportation
Selection of Mode and Supplier
The Functions of Inventory 211
The Forms of Inventory 213
Inventory Function and Form
Framework 213
Inventory Management
232
Role of Logistics in the Economy 233
Role of Supply in Logistics 233
226
9–1 Penner Medical Products 250
9–2 Andrew Morton 251
6/9/10 10:05 PM
xiv
Table of Contents
Chapter 10
Price 253
Limitations of the Exchanges 279
Hedging 279
Sources of Information Regarding Price Trends
Relation of Cost to Price
Meaning of Cost
254
Conclusion 281
Questions for Review and Discussion
References 282
Cases 282
255
How Suppliers Establish Price
256
The Cost Approach 257
The Market Approach 257
Government Influence on Pricing
257
Legislation Affecting Price Determination
Types of Purchases
258
260
Steps in the Bidding Process 263
Firm Bidding 264
Determination of Most Advantageous Bid
Collusive Bidding 265
Public-Sector Bidding 265
The Problem of Identical Prices 267
286
Contract Options for Pricing
264
276
293
Total Cost of Ownership 293
Target Pricing 299
The Learning Curve or Manufacturing Progress
Function 300
Value Engineering and Value Analysis 301
Activity-Based Costing 301
Negotiation
302
Negotiation Strategy and Practice 303
Framework for Planning and Preparing for
Negotiation 304
Conclusion 306
Questions for Review and Discussion
References 307
Cases 308
272
273
Forward Buying versus Speculation 276
Organizing for Forward Buying 277
Control of Forward Buying 277
The Commodity Exchanges 278
290
Cost Management Tools and Techniques
Firm-Fixed-Price (FFP) Contract 273
Cost-Plus-Fixed-Fee (CPFF) Contract 273
Cost-No-Fee (CNF) Contract 273
Cost-Plus-Incentive-Fee (CPIF) Contract 273
Provision for Price Changes 273
Contract Cancellation 275
Forward Buying and Commodities
288
Sources of Competitive Advantage 290
Frameworks for Cost Management 290
268
Cash Discounts 268
Trade Discounts 269
Multiple Discounts 270
Quantity Discounts 270
The Price-Discount Problem 270
Quantity Discounts and Source Selection
Cumulative or Volume Discounts 272
Chapter 11
Cost Management
Strategic Cost Management
The Use of Quotations and Competitive
Bidding 262
joh77899_fm_i-xviii.indd xiv
282
259
Raw Materials/Sensitive Commodities
Special Items 260
Standard Production Items 260
Small-Value Items 261
Capital Goods 262
Services 262
Resale 262
Discounts
10–1 Cottrill Inc. 282
10–2 Coral Drugs 284
10–3 Price Forecasting Exercise
280
11–1 Deere Cost Management
11–2 McMichael Inc. 309
11–3 City of Granston 310
Chapter 12
Supplier Selection
308
313
The Supplier Selection Decision
Decision Trees
307
314
315
Identifying Potential Sources
316
Information Sources 317
Standard Information Requests
321
Additional Supplier Selection Decisions
Single versus Multiple Sourcing
322
322
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Table of Contents xv
Manufacturer versus Distributor 324
Geographical Location of Sources 325
Supplier Size 326
Supplier Development/Reverse Marketing
Evaluating Potential Sources 328
326
Level 1—Strategic 328
Level 2—Traditional 333
Level 3—Current Additional 335
341
12–1 Loren Inc. 342
12–2 Russel Wisselink 346
12–3 Kettering Industries Inc. 348
Chapter 13
Supplier Evaluation and Supplier
Relations 352
353
Key Supplier Performance Indicators 353
Evaluation Methods
354
Informal and Semiformal Evaluation and
Rating 354
Executive Roundtable Discussions 354
Formal Supplier Evaluation and Rating 355
Weighted Point Evaluation Systems 356
Supplier Ranking
357
Unacceptable Suppliers 357
Acceptable Suppliers 358
Preferred Suppliers 358
Exceptional Suppliers 358
Supplier Relations
359
Supplier Relations Context 360
Supplier Goodwill 360
The Purchaser–Supplier Satisfaction Matrix 361
Supplier Relationship Management 364
Partnerships
365
SEMATECH’s Partnering Perspective 365
Early Supplier/Supply Involvement (ESI) 366
Partner Selection 367
The Longer Time Perspective 367
Co-location/In-plants 368
Concerns about Partnerships 368
joh77899_fm_i-xviii.indd xv
370
13–1 APC Europe 371
13–2 Plastic Cable Clips 375
13–3 Delphi Corporation 378
Ranking Potential Suppliers 340
Conclusion 340
Questions for Review and Discussion
References 341
Cases 342
Measuring Supplier Performance
Strategic Alliances 369
Conclusion 370
Questions for Review and Discussion
References 370
Cases 371
Chapter 14
Global Supply Management
The Importance of Global Supply
383
384
Reasons for Global Purchasing 385
Potential Problem Areas 390
Selecting and Managing Offshore
Suppliers 398
Global Sourcing Organizations 398
Intermediaries 399
Information Sources for Locating and Evaluating
Offshore Suppliers 400
Incoterms
401
Group E—Departure 402
Group F—Main Carriage Unpaid 402
Group C—Main Carriage Paid by Seller 402
Group D—Arrival 403
Tools for Global Supply
404
Countertrade 404
Foreign Trade Zones 407
Bonded Warehouses 409
Temporary Importation Bond (TIB) and Duty
Drawbacks 409
Regional Trading Agreements
409
North American Free Trade Agreement (NAFTA) 410
The European Union (EU) 410
ASEAN 410
Mercosur 410
Andean Community 411
The World Trade Organization (WTO) 411
Emerging Markets 411
Conclusion 412
Questions for Review and Discussion
References 413
Cases 413
412
14–1 Trojan Technologies 413
14–2 Marc Biron 415
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Table of Contents
Chapter 15
Legal and Ethics
Corporate Social Responsibility (CSR) 455
Conclusion 455
Questions for Review and Discussion 456
References 456
Cases 457
417
Legal Authority of Buyer and Seller
418
Legal Authority of the Buyer 419
Personal Liability 420
Authority of Suppliers’ Representatives
The Uniform Commercial Code
421
Common Law and the Purchase of Services 431
Principles of the Law of Software Contracts 437
E-Commerce and the Law 437
Electronic Signatures 438
U.S. Uniform Electronic Transactions Act
Antitrust and E-Marketplaces 439
Copyright Law 441
Patents 441
Trademarks 442
Industrial Design 442
Geographical Indication
440
443
444
Commercial Arbitration 444
Mediation 445
Internal Escalation 445
445
The Sarbanes-Oxley Act 446
Environmental Regulations 446
Ethics
447
Perceptions 451
Conflict of Interest 451
Gifts and Gratuities 451
Promotion of Positive Relationships with
Suppliers 454
Reciprocity 454
joh77899_fm_i-xviii.indd xvi
439
Chapter 16
Other Supply Responsibilities
463
Receiving 464
Logistics and Warehousing 465
Inbound and Outbound Transportation
Production Planning 466
Accounts Payable 466
Investment Recovery 466
466
Categories of Material for Disposal 468
Responsibility for Material Disposal 471
Keys to Profitable Disposal 472
Disposal Channels 472
Disposal Procedures 474
Selection of Disposal Partners 475
Conclusion 476
Questions for Review and Discussion
References 477
Cases 478
477
16–1 Ross Wood 478
16–2 Raleigh Plastics 479
Product Liability 443
Alternative Dispute Resolution
Regulatory Requirements
457
422
Purpose of a Uniform Commercial Code 422
The Purchase Order Contract 423
Acceptance of Offers 424
Purchases Made Orally—Statute of Frauds 425
Inspection 426
Acceptance and Rejection of Goods 426
Warranties 428
Title to Purchased Goods 429
Protection against Price Fluctuations 429
Cancellation of Orders and Breach of
Contract 430
Intellectual Property Laws
15–1 Rocky Plains Brewing Ltd.
15–2 Sinclair & Winston 459
Chapter 17
Supply Function Evaluation and
Trends 481
Organizing for Supply Research
483
Full-Time or Part-Time Research Positions
Cross-Functional Teams 484
Supply Research Opportunities
486
Purchased Materials, Products, or Services
Commodities 489
Suppliers 490
Assessing Research Results 493
Supply Planning Process 493
Supply Budgets 493
Performance Measurement Systems
The Value of Supply Metrics
483
486
494
494
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Table of Contents xvii
The Challenges 495
Measuring Supplier Performance 496
Supply Management Performance Metrics 496
Establishing Metrics
498
Efficiency Metrics 498
Effectiveness Metrics 498
Operating Reports 499
Validating Results 500
Appraising Team Performance 500
Supply Performance Benchmarking 501
What Is Happening in Supply Management
Emphasis on Total Quality Management and
Customer Satisfaction 502
Corporate Social Responsibility and
Sustainability 503
Globalization versus Local Sourcing 504
Risk Management 505
Safety and Security 505
joh77899_fm_i-xviii.indd xvii
Supply Processes and Technology 505
Supply Organizations 506
External and Internal Collaboration 506
Metrics and Performance Measurement 507
Innovation 507
Public Procurement 507
Conclusion 507
Questions for Review and Discussion
References 508
Cases 509
502
508
17–1 Randall Corporation 509
17–2 Fairview School Board 510
17–3 Tanton Foods 511
Indexes
Case Index 513
Subject Index 514
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Chapter One
Purchasing and
Supply Management
Chapter Outline
Purchasing and Supply Management
Supply Management Terminology
Supply and Logistics
The Size of the Organization’s Spend
and Financial Significance
Supply Contribution
The Operational versus Strategic
Contribution of Supply
The Direct and Indirect Contribution
of Supply
The Nature of the Organization
Supply Qualifications and Associations
Risk Management
Sustainability
Growth and Influence
Effective Contribution to Organizational
Success
The Organization of This Text
Conclusion
Questions for Review and Discussion
References
Cases
1–1 Qmont Mining
1–2 Erica Carson
1–3 Southeastern University
Challenges Ahead
Supply Chain Management
Measurement
1
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Purchasing and Supply Management
Key Questions for the Supply Decision Maker
Should we
• Rethink how supply can contribute more effectively to organizational goals and
strategies?
• Try to find out what the organization’s total spend with suppliers really is?
• Indentify opportunities for meaningful involvement in major corporate activities?
How can we
• Align our supply strategy with the organization’s strategy?
• Get others to recognize the profit-leverage effect of purchasing/supply
management?
• Show how supply can affect our firm’s competitive position?
Every organization needs suppliers. No organization can exist without suppliers. Therefore, the organization’s approach to suppliers, its acquisition processes and policies, and
its relationships with suppliers will impact not only the performance of the suppliers, but
also the organization’s own performance. No organization can be successful without the
support of its supplier base, operationally and strategically, short- and long-term.
Supply management is focused on the acquisition process recognizing the supply chain
and organizational contexts. Special emphasis is on decision making that aligns the supplier network and the acquisition process with organizational goals and strategies and
ensures short- and long-term value for funds spent.
There is no one best way of organizing the supply function, conducting its activities, and
integrating suppliers effectively. This is both interesting and challenging. It is interesting
because the acquisition of organizational requirements covers a very wide and complex set
of approaches with different needs and different suppliers. It is challenging because of the
complexity and because the process is dynamic, not static. Moreover, some of the brightest minds in this world have been hired as marketing and sales experts to persuade supply
managers to choose their companies as suppliers. It is also challenging because every supply decision depends on a large variety of factors, the combination of which may well be
unique to a particular organization.
For more than 75 years, this text and its predecessors have presented the supply function
and suppliers as critical to an organization’s success, competitive advantage, and customer
satisfaction. Whereas in the 1930s this was a novel idea, over the past few decades there
has been growing interest at the executive level in the supply chain management and its
impact on strategic goals and objectives.
To increase long-term shareholder value, the company must increase revenue, decrease
costs, or both. Supply’s contribution should not be perceived as only focused on cost.
Supply can and should also be concerned with revenue enhancement. What can supply
and suppliers do to help the organization increase revenues or decrease costs? should be a
standard question for any supply manager.
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Chapter 1 Purchasing and Supply Management 3
The supply function continues to evolve as technology and the worldwide competitive environment require innovative approaches. The traditionally held view that multiple
sourcing increases supply security has been challenged by a trend toward single sourcing.
Results from closer supplier relations and cooperation with suppliers question the wisdom
of the traditional arm’s-length dealings between purchaser and supplier. Negotiation is receiving increasing emphasis as opposed to competitive bidding, and longer-term contracts
are replacing short-term buying techniques. E-commerce tools permit faster and lower-cost
solutions, not only on the transaction side of supply but also in management decision support. Organizations are continually evaluating the risks and opportunities of global sourcing. All of these trends are a logical outcome of increased managerial concern with value
and increasing procurement aggressiveness in developing suppliers to meet specific supply
objectives of quality, quantity, delivery, price, service, and continuous improvement.
Effective purchasing and supply management contributes significantly to organizational
success. This text explores the nature of this contribution and the management requirements for effective and efficient performance. The acquisition of materials, services, and
equipment—of the right qualities, in the right quantities, at the right prices, at the right
time, with the right quality, and on a continuing basis—long has occupied the attention of
managers in both the public and private sectors.
Today, the emphasis is on the total supply management process in the context of organizational goals and management of supply chains. The rapidly changing supply scene, with
cycles of abundance and shortages, varying prices, lead times, and availability, provides
a continuing challenge to those organizations wishing to obtain a maximum contribution
from this area. Furthermore, environmental, security, and financial regulatory requirements have added considerable complexity to the task of ensuring that supply and suppliers
provide competitive advantage.
PURCHASING AND SUPPLY MANAGEMENT
Although some people may view interest in the performance of the supply function as a
recent phenomenon, it was recognized as an independent and important function by many
of the nation’s railroad organizations well before 1900.
Yet, traditionally, most firms regarded the supply function primarily as a clerical activity. However, during World War I and World War II, the success of a firm was not dependent on what it could sell, since the market was almost unlimited. Instead, the ability to
obtain from suppliers the raw materials, supplies, and services needed to keep the factories
and mines operating was the key determinant of organizational success. Consequently, attention was given to the organization, policies, and procedures of the supply function, and
it emerged as a recognized managerial activity.
During the 1950s and 1960s, supply management continued to gain stature as the number of people trained and competent to make sound supply decisions increased. Many
companies elevated the chief purchasing officer to top management status, with titles such
as vice president of purchasing, director of materials, or vice president of purchasing and
supply.
As the decade of the 1970s opened, organizations faced two vexing problems: an
international shortage of almost all the basic raw materials needed to support operations
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4
Purchasing and Supply Management
and a rate of price increases far above the norm since the end of World War II. The
Middle East oil embargo during the summer of 1973 intensified both the shortages and
the price escalation. These developments put the spotlight directly on supply, for their
performance in obtaining needed items from suppliers at realistic prices spelled the difference between success and failure. This emphasized again the crucial role played by
supply and suppliers.
As the decade of the 1990s unfolded, it became clear that organizations must have an
efficient and effective supply function if they were to compete successfully in the global
marketplace. The early 21st century has brought new challenges in the areas of sustainability, supply chain security, and risk management.
In large supply organizations, supply professionals often are divided into two categories: the tacticians who handle day-to-day requirements and the strategic thinkers who
possess strong analytical and planning skills and are involved in activities such as strategic
sourcing. The extent to which the structure, processes, and people in a specific organization will match these trends varies from organization to organization, and from industry to
industry.
The future will see a gradual shift from predominantly defensive strategies, resulting
from the need to change in order to remain competitive, to aggressive strategies, in which
firms take an imaginative approach to achieving supply objectives to satisfy short-term
and long-term organizational goals. The focus on strategy now includes an emphasis on
process and knowledge management. This text discusses what organizations should do
today to remain competitive as well as what strategic, integrated purchasing and supply
management will focus on tomorrow.
Growing management interest through necessity and improved insight into the opportunities in the supply area has resulted in a variety of organizational concepts. Terms such
as purchasing, procurement, materiel, materials management, logistics, sourcing, supply
management, and supply chain management are used almost interchangeably. No agreement exists on the definition of each of these terms, and managers in public and private
institutions may have identical responsibilities but substantially different titles. The following definitions may be helpful in sorting out the more common understanding of the
various terms.
Supply Management Terminology
Some academics and practitioners limit the term purchasing to the process of buying:
learning of the need, locating and selecting a supplier, negotiating price and other pertinent terms, and following up to ensure delivery and payment. This is not the perspective
taken in this text. Purchasing, supply management, and procurement are used interchangeably to refer to the integration of related functions to provide effective and efficient
materials and services to the organization. Thus, purchasing or supply management is not
only concerned with the standard steps in the procurement process: (1) the recognition of
need, (2) the translation of that need into a commercially equivalent description, (3) the
search for potential suppliers, (4) the selection of a suitable source, (5) the agreement on
order or contract details, (6) the delivery of the products or services, and (7) the payment
of suppliers.
Further responsibilities of supply may include receiving, inspection, warehousing, inventory control, materials handling, packaging scheduling, in- and outbound transportation/
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Chapter 1 Purchasing and Supply Management 5
traffic, and disposal. Supply also may have responsibility for other components of the supply chain, such as the organization’s customers and their customers and their suppliers’
suppliers. This extension represents the term supply chain management, where the focus is
on minimizing costs and lead times across tiers in the supply chain to the benefit of the final
customer. The idea that competition may change from the firm level to the supply chain
level has been advanced as the next stage of competitive evolution.
In addition to the operational responsibilities that are part of the day-to-day activities
of the supply organization, there are strategic responsibilities. Strategic sourcing focuses
on long-term supplier relation and commodity plans with the objectives of identifying
opportunities in areas such as cost reductions, new technology advancements, and supply
market trends. The Sabor case in Chapter 2 provides an excellent example of the need to
take a strategic perspective when planning long-term supply needs.
Lean purchasing or lean supply management refers primarily to a manufacturing context and the implementation of just-in-time (JIT) tools and techniques to ensure every step
in the supply process adds value, that inventories are kept at a minimum level, and that
distances and delays between process steps are kept as short as possible. Instant communication of job status is essential and shared.
Supply and Logistics
The large number of physical moves associated with any purchasing or supply chain activity has focused attention on the role of logistics. According to the Council of Supply Chain
Management Professionals, “Logistics management is that part of supply chain management that plans, implements, and controls the efficient, effective forward and reverse flow
and storage of goods, services, and related information between the point of origin and
the point of consumption in order to meet customers’ requirements.”1 This definition includes inbound, outbound, internal, and external movements. Logistics is not confined to
manufacturing organizations. It is relevant to service organizations and to both private- and
public-sector firms.
The attraction of the logistics concept is that it looks at the material flow process as
a complete system, from initial need for materials to delivery of finished product or service to the customer. It attempts to provide the communication, coordination, and control
needed to avoid the potential conflicts between the physical distribution and the materials
management functions.
Supply influences a number of logistics-related activities, such as how much to buy
and inbound transportation. With an increased emphasis on controlling materials flows,
the supply function must be concerned with decisions beyond supplier selection and price.
The Qmont Mining case at the end of this chapter illustrates the logistics considerations of
supplying multiple locations.
Some companies, such as Procter & Gamble and Goodyear, are combining supply and
logistics into a single organization. For example P&G appointed a new director of logistics
purchases in 2006 as part of a broader centralization project at the consumer products company. Global sourcing leader positions were created for transportation, warehousing, pallets, cross border, and inbound logistics. The sourcing leaders worked closely with regional
1
Council of Supply Chain Management Professionals, Glossary of Terms, http://www.cscmp.org
(accessed January 10, 2010).
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6
Purchasing and Supply Management
operations and logistics teams to develop strategies and action plans to improve supply
chain effectiveness and reduce costs.2
Supply chain management is a systems approach to managing the entire flow of information, materials, and services from raw materials suppliers through factories and warehouses to the end customer. The Institute for Supply Management (ISM) glossary defines
supply chain management as “the design and management of seamless, value-added processes across organizational boundaries to meet the real needs of the end customer. The
development and integration of people and technological resources are critical to successful supply chain integration.”3
The term value chain has been used to trace a product or service through its various
moves and transformations, identifying the costs added at each successive stage.
Some academics and practitioners believe the term chain does not properly convey what
really happens in a supply or value chain, and they prefer to use the term supply network
or supply web.
The use of the concepts of purchasing, procurement, supply, and supply chain management will vary from organization to organization. It will depend on (1) their stage of development and/or sophistication, (2) the industry in which they operate, and (3) their competitive
position.
The relative importance of the supply area compared to the other prime functions of the
organization will be a major determinant of the management attention it will receive. How
to assess the materials and services needs of a particular organization in context is one of
the purposes of this book. More than 40 cases are provided to provide insight into a variety
of situations and to give practice in resolving managerial problems.
THE SIZE OF THE ORGANIZATION’S SPEND
AND FINANCIAL SIGNIFICANCE
The amount of money organizations spend with suppliers is staggering. Collectively, private
and public organizations in North America spend about 1.5 times the GDPs of the United
States, Canada, and Mexico combined, totaling at least $26 trillion U.S. Dollars spent with
suppliers as a percentage of total revenue are a good indicator of supply’s financial impact.
Obviously, the percentage of revenue that is paid out to suppliers varies from industry to
industry and organization to organization, and increased outsourcing over the last decade
has increased the percentage of spend significantly. In almost all manufacturing organizations, the supply area represents by far the largest single category of spend, ranging from
50 to 80 percent of revenue. Wages, by comparison, typically amount to about 10 to 20 percent. In comparison, the total dollars spent on outside suppliers typically ranges from 25 to
35 percent of revenues. The Delphi Corporation case in Chapter 15 is a good illustration of
the significance of spend in a manufacturing organization. Total purchases were $17 billion
compared to revenues of $28 billion.
The financial impact of the corporate spend is often illustrated by the profit-leverage
effect and the return-on-assets effect.
2
3
joh77899_ch01_001-025.indd 6
D. Hannon, “Purchasing Drives Deeper into Logistics,” Purchasing 138, no. 7 (2009), p. 76.
Institute for Supply Management, “Glossary of Key Supply Management Terms,” http://www.ism.ws.
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Chapter 1 Purchasing and Supply Management 7
Profit-Leverage Effect
The profit-leverage effect of supply savings is measured by the increase in profit obtained by
a decrease in purchase spend. For example, for an organization with revenue of $100 million, purchases of $60 million, and profit of $8 million before tax, a 10 percent reduction
in purchase spend would result in an increase in profit of 75 percent, giving a leverage of
7.5. To achieve a $6,000,000 increase in profit by increasing sales, assuming the same percentage hold, might well require an increase of $75 million in sales, or 75 percent! Which
of these two options—an increase in sales of 75 percent or a decrease in purchase spend of
10 percent—is more likely to be achieved?
This is not to suggest that it would be easy to reduce overall purchase costs by 10 percent. In a firm that has given major attention to the supply function over the years, it would
be difficult, and perhaps impossible, to do. But, in a firm that has neglected supply, it would
be a realistic objective. Because of the profit-leverage effect of supply, large savings are
possible relative to the effort that would be needed to increase sales by the much-larger
percentage necessary to generate the same effect on the profit and loss (P&L) statement.
Since, in many firms, sales already has received much more attention, supply may be the
last untapped “profit producer.”
Return-on-Assets Effect
Financial experts are increasingly interested in return on assets (ROA) as a measure of
corporate performance. Figure 1–1 shows the standard ROA model, using the same ratio
of figures as in the previous example, and assuming that inventory accounts for 30 percent
of total assets. If purchase costs were reduced by 10 percent, that would cause an extra benefit of a 10 percent reduction in the inventory asset base. The numbers in the boxes show
the initial figures used in arriving at the 10 percent ROA performance.
FIGURE 1–1
Sales
$1 million
Return-onAssets Factors
Divided by
*
Inventory
$150,000
Total
assets
$500,000
($135,000)
($485,000)
Investment
turnover 2
(2.06)
Multiplied by
Sales
$1 million
Minus
†
Total cost
$950,000
†† ($900,000)
ROA
10%
(20.6%)
Profit
$50,000
($100,000)
Divided by
Sales
$1 million
Profit
margin
5%
(10%)
*Inventory is approximately 30 percent of total assets.
†
Purchases account for half of total sales, or $500,000.
††
Figures in parentheses assume a 10 percent reduction in purchase costs.
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8
Purchasing and Supply Management
The numbers below each box are the figures resulting from a 10 percent overall purchase price reduction, and the end product is a new ROA of 20.6 percent or about an
100 percent increase in return on assets.
Reduction in Inventory Investment
Charles Dehelly, senior executive vice president at Thomson Multimedia, headquartered
in Paris, France, said: “It came as quite a surprise to some supply people that I expected
them to worry about the balance sheet by insisting on measuring their return on capital
employed performance.”4 Mr. Dehelly was pushing for reductions in inventory investment, not only by lowering purchase price, as shown in the example in Figure 1–1, but
also by getting suppliers to take over inventory responsibility and ownership, thereby removing asset dollars in the ROA calculations, but also taking on the risk of obsolescence
and inventory carrying and disposal costs. Since accountants value inventory items at
the purchaser at purchased cost, including transportation, but inventory at the supplier at
manufacturing cost, the same items stored at the supplier typically have a lower inventory
investment and carrying cost.
Thus, it is a prime responsibility of supply to manage the supply process with the lowest reasonable levels of inventory attainable. Inventory turnover and level are two major
measures of supply chain performance.
Evidently, the financial impact of supply is on the balance sheet and the income statement, the two key indicators of corporate financial health used by managers, analysts,
financial institutions, and investors. While the financial impact of the supply spend is obviously significant, it is by no means the only impact of supply on an organization’s ability
to compete and be successful.
SUPPLY CONTRIBUTION
Although supply’s financial impact is major, supply contributes to organizational goals and
strategies in a variety of other ways. The three major perspectives on supply are shown in
Figure 1–2:
1. Operational versus strategic.
2. Direct and indirect.
3. Negative, neutral, and positive.
The Operational versus Strategic Contribution of Supply
First, supply can be viewed in two contexts: operational, which is characterized as trouble
avoidance, and strategic, which is characterized as opportunistic.
The operational context is the most familiar. Many people inside the organization are
inconvenienced to varying degrees when supply does not meet minimum expectations.
Improper quality, wrong quantities, and late delivery may make life miserable for the ultimate user of the product or service. This is so basic and apparent that “no complaints” is
4
M. R. Leenders and P. F. Johnson, Major Changes in Supply Chain Responsibilities (Tempe, AZ: CAPS
Research, March 2002), p. 104.
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Chapter 1 Purchasing and Supply Management 9
FIGURE 1–2
Purchasing’s
Operational
and Strategic
Contributions
Source: Michiel R.
Leenders and Anna
E. Flynn, ValueDriven Purchasing:
Managing the
Key Steps in the
Acquisition Process
(Burr Ridge, IL:
Richard D. Irwin,
1995), p. 7.
1. Supply contribution
Operational
Strategic
Trouble prevention
Opportunity maximization
2. Supply contribution
Direct
Indirect
Bottom-line impact
Enhancing performance of others
3. Supply contribution
Negative
Neutral
Positive
Operationally deficient
Strategically deficient
Directly deficient
Indirectly deficient
Operationally acceptable
Strategically deficient
Directly acceptable
Indirectly deficient
Operationally acceptable
Strategically acceptable
Directly acceptable
Indirectly acceptable
assumed to be an indicator of good supply performance. The difficulty is that many users
never expect anything more and hence may not receive anything more.
The operational side of supply concerns itself with the transactional, day-to-day operations traditionally associated with purchasing. The operational side can be streamlined and
organized in ways designed to routinize and automate many of the transactions, thus freeing up time for the supply manager to focus on the strategic contribution.
The strategic side of supply is future oriented and searches for opportunities to provide
competitive advantage. Whereas on the operational side the focus is on executing current
tasks as designed, the strategic side focuses on new and better solutions to organizational
and supply challenges. (Chapter 2 discusses the strategic side in detail.)
The Direct and Indirect Contribution of Supply
The second perspective is that of supply’s potential direct or indirect contribution to organizational objectives.
Supply savings, the profit-leverage effect, and the return-on-assets effect demonstrate
the direct contribution supply can make to the company’s financial statements. Although
the argument that supply savings flow directly to the bottom line appears self-evident, experience shows that savings do not always get that far. Budget heads, when presented with
savings, may choose to spend this unexpected windfall on other requirements.
To combat this phenomenon, some supply organizations have hired financial controllers to assure that supply savings do reach the bottom line. Such was the case at Praxair,
a global supplier of specialty gases and technologies. The chief supply officer and the
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10 Purchasing and Supply Management
CFO agreed that a financial controller position was needed in the supply organization
to support financial analysis and budgeting. Validating cost savings and linking cost
savings to the business unit operating budgets were an important part of this person’s
responsibilities.5
The appeal of the direct contribution of supply is that both inventory reduction and purchasing savings are measurable and tangible evidence of supply contribution.
The supply function also contributes indirectly by enhancing the performance of other
departments or individuals in the organization. This perspective puts supply on the management team of the organization. Just as in sports, the team’s objective is to win. Who
scores is less important than the total team’s performance. For example, better quality
may reduce rework, lower warranty costs, increase customer satisfaction, and /or increase
the ability to sell more or at a higher price. Ideas from suppliers may result in improved
design, lower manufacturing costs, and/or a faster idea-to-design-to-product-completionto-customer-delivery cycle. Each would improve the organization’s competitiveness.
Indirect contributions come from supply’s role as an information source; its effect on
efficiency, competitive position, risk, and company image; the management training provided by assignments in the supply area; and its role in developing management strategy
and social policy. The benefits of the indirect contribution may outweigh the direct contribution, but measuring the indirect benefits is difficult since it involves many “soft” or
intangible contributions that are difficult to quantify.
Information Source
The contacts of the supply function in the marketplace provide a useful source of information for various functions within the organization. Primary examples include information
about prices, availability of goods, new sources of supply, new products, and new technology, all of interest to many other parts of the organization. New marketing techniques and
distribution systems used by suppliers may be of interest to the marketing group. News
about major investments, mergers, acquisition candidates, international political and economic developments, pending bankruptcies, major promotions and appointments, and
current and potential customers may be relevant to marketing, finance, research, and top
management. Supply’s unique position vis-à-vis the marketplace should provide a comprehensive listening post.
Effect on Efficiency
The efficiency with which supply processes are performed will show up in other operating
results. While the firm’s accounting system may not be sophisticated enough to identify
poor efficiency as having been caused by poor purchase decisions, that could be the case. If
supply selects a supplier who fails to deliver raw materials or parts that measure up to the
agreed-on quality standards, this may result in a higher scrap rate or costly rework, requiring excessive direct labor expenditures. If the supplier does not meet the agreed-on delivery
schedule, this may require a costly rescheduling of production, decreasing overall production efficiency, or, in the worst case, a shutdown of the production line—and fixed costs
continue even though there is no output. Many supply managers refer to user departments
5
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Leenders and Johnson, Major Changes in Supply Chain Responsibilities, p. 89.
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Chapter 1 Purchasing and Supply Management 11
as internal customers or clients and focus on improving the efficiency and effectiveness of
the function with a goal of providing outstanding internal customer service.
Effect on Competitive Position/Customer Satisfaction
A firm cannot be competitive unless it can deliver end products or services to its customers when they are wanted, of the quality desired, and at a price the customer feels is fair.
If supply doesn’t do its job, the firm will not have the required materials or services when
needed, of desired quality, and at a price that will keep end-product costs competitive and
under control.
The ability of the supply organization to secure requirements of better quality, faster at
a better price than competitors, will not only improve the organization’s competitive position, but also improve customer satisfaction. The same can be said for greater flexibility
to adjust to customers’ changing needs. Thus, a demonstrably better-performing supply
organization is a major asset on any corporate team.
A major chemical producer was able to develop a significantly lower-cost option for a
key raw material that proved to be environmentally superior as well as better quality. By
selling its better end product at somewhat lower prices, the chemical producer was able to
double its market share, significantly improving its financial health and competitive position as well as the satisfaction of its customers.
Effect on Organizational Risk
Risk management is becoming an ever-increasing concern. The supply function clearly
impacts the risk level for the organization in terms of operational, financial, and reputation
risk. Supply disruptions in terms of energy, service, or direct or indirect requirements can
impact the ability of the organization to operate as planned and as expected by its customers, creating operational risks.
Given that commodity and financial markets establish prices that may go up or down
beyond the control of the individual purchaser, and that long-term supply agreements require price provisions, the supply area may represent a significant level of financial risk.
Furthermore, unethical or questionable supply practices and suppliers may expose the organization to significant reputation risk.
Effect on Image
The actions of supply personnel influence directly the public relations and image of a company. If actual and potential suppliers are not treated in a businesslike manner, they will
form a poor opinion of the entire organization and will communicate this to other firms.
This poor image will adversely affect the purchaser’s ability to get new business and to
find new and better suppliers. Public confidence can be boosted by evidence of sound and
ethical policies and fair implementation of them.
The large spend of any organization draws attention in terms of supplier chosen, the
process used to choose suppliers, the ethics surrounding the supply process, and conformance to regulatory requirements. Are the suppliers chosen “clean” in terms of child labor,
environmental behavior, and reputation? Is the acquisition process transparent and legally,
ethically, strategically, and operationally defensible as sound practice? Do supply’s actions
take fully into account environmental, financial, and other regulatory requirements such as
national security?
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12 Purchasing and Supply Management
Maintaining a proper corporate image is the responsibility of every team member and
supply is no exception.
Training Ground
The supply area also is an excellent training ground for new managers. The needs of
the organization may be quickly grasped. Exposure to the pressure of decision making
under uncertainty with potentially serious consequences allows for evaluation of the
individual’s ability and willingness to make sound decisions and assume responsibility. Contacts with many people at various levels and a variety of functions may assist
the individual in learning about how the organization works. Many organizations find
it useful to include the supply area as part of a formal job rotation system for highpotential employees.
Examples of senior corporate executives with significant supply experience include
Thomas T. Stallkamp, vice chairman and CEO of MSX International, Inc., and former
Chrysler president; Willie A. Deese, executive vice president and president, Merck Manufacturing Division; Richard B. Jacobs, general manager of Eaton Corporation’s Fluid
Power Group’s Filtration Division.
Management Strategy
Supply also can be used as a tool of management strategy and social policy. Does management wish to introduce and stimulate competition? Does it favor geographical representation, minority interest, and environmental and social concerns? For example, are domestic
sources preferred? Will resources be spent on assisting minority suppliers? As part of
an overall organization strategy, the supply function can contribute a great deal. Assurance of supply of vital materials or services in a time of general shortages can be a major
competitive advantage. Similarly, access to a better-quality or a lower-priced product or
service may represent a substantial gain. These strategic positions in the marketplace may
be gained through active exploration of international and domestic markets, technology,
innovative management systems, and the imaginative use of corporate resources. Vertical
integration and its companion decisions of make or buy (insource or outsource) are everpresent considerations in the management of supply.
The potential contribution of supply to strategy is obvious. Achievement depends on
both top executive awareness of this potential and the ability to marshal corporate resources to this end. At the same time, it is the responsibility of those charged with the
management of the supply function to seek strategic opportunities in the environment and
to draw top executive attention to them. This requires a thorough familiarity with organizational objectives, strategy, and long-term plans and the ability to influence these in the light
of new information. Chapter 2 discusses both potential supply contributions to business
strategy and the major strategy areas within the supply function.
Progressive managers have recognized the potential contributions of the supply management area and have taken the necessary steps to ensure results. One important step
in successful organizations has been the elevation to top executive status of the supply
manager. Although titles are not always consistent with status and value in an organization, they still make a statement within and outside of most organizations. Currently, the
most common title of the chief supply officer is vice president, followed by director and
manager.
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Chapter 1 Purchasing and Supply Management 13
The elevation of the chief supply officer to executive status, coupled with high-caliber
staff and the appropriate authority and responsibility, has resulted in an exciting and fruitful realization of the potential of the supply function in many companies.
THE NATURE OF THE ORGANIZATION
The nature of the organization will determine how it will structure and manage its supply
function. Whether the organization is public or private and produces goods or services or
both, its mission, vision, and strategies, its size, number of sites, location, financial strength,
and reputation will all be factors influencing its supply options and decisions. These will be
addressed broadly in this first chapter and will be added to subsequently in this text.
Public or Private Organization
Public institutions, including all levels of government from municipal to state or provincial to federal, tend to be service providers but are not exclusively so, and are subject to
strict regulatory requirements regarding acquisition processes and policies. The public
sector in many countries also includes education, health, utilities, and a host of agencies,
boards, institutes, and so forth. The Southeastern University case at the end of this chapter
provides an example of supply in a public-sector context at a state university. This case
illustrates how many purchases in the public sector can be for capital and indirect supplies, which creates challenges for supply to influence purchasing decisions that ensure
best value.
A large segment of the acquisition needs of public institutions is concerned with the
support of the organization’s mission and maintenance of facilities and offices. Concerns
over public spending deal with transparency and fairness of access to all eligible suppliers,
social aims such as support of minority and disadvantaged groups, and national security.
Need definition and specification are often part of the supply manager’s responsibilities
and are often geared to allow for multiple bidders.
That not all public organizations are alike is evident from Figure 1–3 which shows just
some of the differences among public bodies.
Nongovernmental organizations (NGOs) and other nonprofit organizations would
have a breakdown similar to those listed for public organizations, but might also operate
internationally.
Private Organizations
Private organizations, which include companies with publicly traded stocks, tend to have
fewer constraints on need definition, specification, and supplier selection. The laws of the
FIGURE 1–3
Differentiations
for Supply
Management
in Public
Organizations
joh77899_ch01_001-025.indd 13
Level:
Municipal
Mission:
Social Aims
Revenue Generation:
Limited
Size:
Small
Medium
Large
Number of Sites:
Single
Few
Many
State or Provincial
Other or Combination
Combination
Federal
Economic
Substantial
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14 Purchasing and Supply Management
FIGURE 1–4 Differentiations for Supply Management in Private Organizations
Goods or Services:
Manufacturer
Combination
Services
Strategy:
Low cost
Combination
Differentiation
Size:
Small
Medium
Large
Number of Sites:
Single
Few
Many
Location:
Domestic
Financial Strength:
Weak
Medium
Strong
Reputation:
Poor
Medium
Outstanding
Few International
Many International
land (covered in Chapter 14) will establish the main ground rules for commerce. Transparency of commitments with suppliers has recently become more relevant to ensure that longterm commitments are properly disclosed in the company’s financial statements. Whereas
in public institutions standardization is seen as a means of fairness to suppliers, in private
companies, custom specifications are seen as a means of securing competitive advantage.
Figure 1–4 shows some of the influencers that will affect supply management in private
organizations. It is clear that for both public and private organizations these differences
will affect supply significantly and some generalizations on supply impact follow.
Goods or Service Producers
Another major supply influence is whether the organization produces goods or services or
both. Goods producers, often called manufacturers, may produce a wide range of products,
both in the industrial goods category and in consumer goods. For goods producers, normally
the largest percentage of total spend of the organization is on materials, purchased parts,
packaging, and transportation for the goods produced. For service providers (and the range
of possible services is huge), normally the largest percent of spend is focused on services
and the process enabling the delivery of the services. The Erica Carson case in this chapter
describes a supply decision in a large services organization, a financial institution. This case
illustrates the opportunities for supply to contribute to the customer value proposition.
The following table identifies what the impact on organizational requirements is likely
to be depending on whether the organization is primarily focused on manufacturing or
providing a service:
Manufacturer
Service Provider
• The largest portion of needs is generated by customer needs.
• The largest portion of spend with suppliers will be on direct requirements
which comprise products sold to
customers.
• The largest portion of needs is generated by capital, services, and other
requirements enabling employees to
provide the service.
• In retailing the largest spend is
focused on resale requirements.
Very few organizations are pure manufacturers or service providers. Most represent a mixture of both. A restaurant provides meals and drinks as well as service and a place to eat.
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Chapter 1 Purchasing and Supply Management 15
An insurance company provides insurance policies and claim service as well as peace of
mind. An R&D organization performs research, as well as research reports, models, and
prototypes. A manufacturer may supply capital goods as well as repair service and availability of replacement parts.
Wholesalers, distributors, and retailers provide resale products in smaller quantities and
in more convenient locations at more convenient times than the manufacturers can provide.
For these resellers the ability to buy well is critical for success.
Resource and mining organizations explore for natural resources and find ways and
means of bringing these to commodity markets. Educational institutions attempt to transform students into educated persons, frequently providing them with meals, residences,
classrooms, parking facilities, and, hopefully, diplomas or degrees. Health organizations
provide diagnostic and repair services using a very large variety of professionals, equipment, facilities, medicines, and parts to keep their clients healthy and functioning.
It is no surprise that the nature of the organization in terms of the goods and services it
provides will significantly affect the requirements of its supply chain.
The Mission, Vision, and Strategy of the Organization
Supply strategy has to be congruent with organizational strategy. Therefore, the mission,
vision, and strategy of the organization are the key drivers for how the supply function will
be managed and how supply decisions are made and executed. A nonprofit organization
with social aims may acquire its office needs totally differently from one that competes on
cost in a tough commercial or consumer marketplace. An innovation-focused organization
may define flexibility quite differently from one that depends largely on the acquisition and
transformation or distribution of commodities.
In the past, the supply manager was largely focused on the traditional value determinants of quality, quantity, delivery, price, and service as the five key drivers of sound
supply decisions. Today’s supply managers face a host of additional concerns, as corporate mission, vision, and strategies require concerns over risk, the environment, social
responsibility, transparency, regulation, and innovation as well. Thus, the old adage of
value for money, a guiding principle for supply managers for centuries, has become a lot
tougher over the last few decades and continues to evolve. The text and cases in this book
are focused on major supply decisions appropriate for the unique organization in which the
supply professional is employed.
The Size of the Organization
The larger the organization, the greater the absolute amount of spend with suppliers. And
the amount of the spend will be a major determinant of how many resources can be allocated
to the acquisition process. Given a cost of acquisition of 1 to 2 percent of what is acquired,
for a $100,000 purchase, up to $2,000 can be spent on acquisition. However, a $100 million
acquisition can afford up to $2 million and a $1 billion spend up to $20 million.
Therefore, the larger the amount of spend, the greater the time and care that can and
should be allocated to acquisition. Therefore, in very small organizations, the responsibility for acquisition may be a part-time allocation to one or more individuals who probably
wear multiple hats. In very large organizations, supply professionals may be completely
dedicated to one category of requirements on a full-time basis. And a supply group may
count hundreds of professionals. Military acquisition in the United States occupies over
40,000 people, a very large supply chain operation.
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16 Purchasing and Supply Management
Single or Multiple Sites
An additional influence is whether the organization operates out of a single or multiple
sites. The simplest situation is the single site. The supply situation becomes more complex
as the number of sites increases. Transportation and storage issues multiply with multiple
sites along with communication and control challenges. This is especially true for multinationals supplying multiple sites in a large variety of countries.
Financial Strength
Supply management stripped to its bare essentials deals with the exchange of money for
goods and services. With the acquiring company responsible for the money and the supplier for the goods and services, the ability of the buying organization to pay will be a very
important issue in the supplier’s eyes. And the ability to pay and flexibility on when to pay
depend on the financial strength of the organization. The stronger the buying organization
is financially, the more attractive it becomes as a potential customer. A supplier will be
more anxious to offer an exceptionally good value proposition to an attractive customer.
And the ability and willingness to pay quickly after receipt of goods or services add valuable bargaining chips to any purchaser.
Reputation
Corporate reputation in the trade is another important factor in building a positive corporate image both for suppliers and purchasers. If supply management is defined as the fight
for superior suppliers, then a strong corporate image and reputation are valuable contributors. Superior suppliers can pick and choose their customers. Superior suppliers prefer to
deal with superior customers. Superior customers enhance a superior supplier’s reputation.
“You are known by the company you keep” applies in the corporate world just like it does
in personal life. And supply managers can significantly affect their company’s image by
their actions and relations with suppliers.
For a long time the reputation of Fisher & Paykel (F&P) in New Zealand and Australia
was such that any F&P supplier could use this as a persuasive argument for gaining
additional customers in that area of the world. “If you are good enough to supply F&P, you
are good enough for us” was the implication. A good buyer–supplier relationship is built
on the rock of impeccable performance to contract agreements. Pay the right amount on
time without hassle and deliver the right quality and quantity of goods or services on time
and charge the correct price without hassle. These commitments are not as simple as they
sound. Moreover, superior customers and superior suppliers add ethical treatment; advance
communications on future developments in technology, markets, and opportunities for improvements as additional expectations; and are continually striving to do better.
Corporate reputations are built on actions and results, not on noble intentions. It takes
time to build a superior reputation, but not much time to harm a reputation.
SUPPLY QUALIFICATIONS AND ASSOCIATIONS
In recognition that the talent in supply has to match the challenges of the profession, public
and private organizations as well as supply associations have taken the initiative to ensure
well-qualified supply professionals are available to staff the function.
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Chapter 1 Purchasing and Supply Management 17
Education
Although there are no universal educational requirements for entry-level supply jobs, most
large organizations require a college degree in business administration or management.
Several major educational institutions, such as Arizona State University, Bowling Green
State University, George Washington University, Miami University, Michigan State University, and Western Michigan University, now offer an undergraduate degree major in
Purchasing/Supply/Supply Chain/Logistics Management as part of the bachelor in business administration degree. In addition, many schools offer certificate programs or some
courses in supply, for either full- or part-time students. A number of schools, including
Arizona State, Michigan State, and Howard University, also offer a specialization in supply chain management as part of a master of business administration degree program.
In Canada, the Richard Ivey School of Business has offered for over 60 years a purchasing and supply course as part of its undergraduate and graduate degree offerings. Other universities such as HEC, Laval, York, Queens, University of British Columbia, and Victoria
have followed suit; academic interest in supply chain management is at an all-time high.
While, obviously, a university degree is not a guarantee of individual performance and
success, the supply professional with one or more degrees is perceived on an educational
par with professionals in other disciplines such as engineering, accounting, marketing, information technology (IT), human resources (HR), or finance. That perception is important
in the role that supply professionals are invited to play on the organizational team.
Professional Associations
As any profession matures, its professional associations emerge as focal points for efforts
to advance professional practice and conduct. In the United States, the major professional
association is the Institute for Supply Management (ISM), founded in 1915 as the National
Association of Purchasing Agents. The ISM is an educational and research association
with over 40,000 members who belong to ISM through its network of domestic and international affiliated associations.
In addition to regional and national conferences, ISM sponsors seminars for supply
people. It publishes a variety of books and monographs and the leading scholarly journal in
the field, The Journal of Supply Chain Management, which it began in 1965. Additionally,
ISM and its Canadian counterpart, the Purchasing Management Association of Canada
(PMAC), work with colleges and universities to encourage and support the teaching of
purchasing and supply management and related subjects and provide financial grants to
support doctoral student research.
ISM launched the Certified Professional in Supply Management (CPSM) program in
May 2008. The CPSM program focuses skill development in areas such as supplier relationship management, commodity management, risk and compliance issues, and social
responsibility.
Since the early 1930s, ISM has conducted the monthly “ISM Report on Business,”
which is one of the best-recognized current barometers of business activity in the manufacturing sector. In 1998, the association initiated the Nonmanufacturing ISM Report on
Business. The survey results are normally released on the second business day of each
month. The Ivey Purchasing Managers Index (Ivey PMI), jointly sponsored by PMAC and
the Richard Ivey School of Business, is the Canadian equivalent of ISM’s Report on Business, but covers the complete Canadian economy.
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18 Purchasing and Supply Management
In 1986, CAPS Research (formally the Center for Advanced Purchasing Studies) was
established as a national affiliation agreement between ISM and the College of Business at
Arizona State University. CAPS is dedicated to the discovery and dissemination of strategic supply management knowledge and best practices. It conducts industry wide purchasing benchmarking studies, publishes a good practices publication called Practix, runs the
annual Purchasing Executives’ Roundtables, and conducts and publishes focused purchasing research in areas of interest to industry.
In Canada, the professional association is the PMAC, formed in 1919. Its membership of approximately 6,000 is organized in 10 provincial and territorial institutes from
coast to coast. Its primary objective is education, and in addition to sponsoring national
conferences and publishing a magazine, it offers an accreditation program leading to the
CPP (Certified Professional Purchaser) designation. PMAC’s accreditation program was
started in 1963.
In addition to ISM and PMAC, there are other professional purchasing associations, such as the National Institute of Governmental Purchasing (NIGP), the National
Association of State Purchasing Officials (NASPO), the National Association of
Educational Buyers (NAEB), and the American Society for Health Care Materials
Management.
Several of these associations offer their own certification programs. Most industrialized countries have their own professional purchasing associations: for example, Institute
of Purchasing and Supply Management (Australia), Chartered Institute of Purchasing and
Supply (Great Britain), Indian Institute of Materials Management, and Japan Materials
Management Association. These national associations are loosely organized into the International Federation of Purchasing and Supply Management (IFPSM), which has as its objective the fostering of cooperation, education, and research in purchasing on a worldwide
basis among the more than 40 member national associations representing approximately
200,000 supply professionals.
CHALLENGES AHEAD
There are at least six major challenges facing the supply profession over the next decade:
supply chain management, measurement, risk management, sustainability, growth and influence, and effective contribution to corporate success.
Supply Chain Management
The success of firms like Walmart and Zara in exploiting supply chain opportunities has
helped popularize the whole field of supply chain management. Nevertheless, significant
challenges remain: While the giant firms in automotive, electronics, and retailing can force
the various members of the supply chain to do their bidding, smaller companies do not
have that luxury. Thus, each organization has to determine for itself how far it can extend
its sphere of influence within the supply chain and how to respond to supply chain initiatives by others. Clearly, opportunities to reduce inventories, shorten lead times and distances, plan operations better, remove uncertainties, and squeeze waste out of the supply
chain are still abundant. Thus, the search for extra value in the supply chain will continue
for a considerable period of time.
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Chapter 1 Purchasing and Supply Management 19
Measurement
There is significant interest in better measurement of supply not only to provide senior
management with better information regarding supply’s contribution, but also to be able to
assess the benefits of various supply experiments. No one set of measurements is likely to
suffice for all supply organizations. Therefore, finding the set of measures most appropriate
for a particular organization’s circumstances is part of the measurement challenge.
Risk Management
A recent study at Michigan State University found that supply chain disruptions and supply
chain risk are among the most critical issues facing supply chain managers.6 Supply chains
have become increasingly global and, therefore, face risks of supply interruptions, financial
and exchange rate fluctuations, lead time variability, and security and protection of intellectual property rights, to name only a few. The trend to single sourcing has also created
the increased risks for supply disruptions.
Supply managers need to continually assess risks in the supply chain and balance risk/
reward opportunities when making supply decisions. For example, the attraction of lower
prices from an offshore supplier may create longer-term high costs as a result of the need to
carry additional safety stock inventories or lost sales from stock-outs. The Russel Wisselink
case in Chapter 12 describes how one organization ran into problems in a low cost country
sourcing program. Risk management will be covered in more detail in Chapter 2.
Sustainability
Responsibility for reverse logistics and disposal has traditionally fallen under the supply
organization umbrella (see Chapters 16 and 17). These activities include the effective and
efficient capture and disposition of downstream products from customers. More recently,
however, pressures from government and consumer groups are motivating organizations
to reduce the impact of their supply chains on the natural environment. For example, the
European Union (EU) has set aggressive targets for greenhouse gas reductions and cuts
to overall energy consumption, and has implemented new legislation as a result. Supply
will be at the forefront of sustainability initiatives. Senior management will expect supply to work with suppliers to identify solutions for the environmental and sustainability
challenges they face.
Growth and Influence
Growth and influence in terms of the role of supply and its responsibilities inside an organization can be represented in four areas as identified in a recent CAPS study.7 In the
first place, supply can grow in the percentage of the organization’s total spend for which
it is meaningfully involved. Thus, categories of spend traditionally not involving purchasing, such as real estate, insurance, energy, benefit programs, part-time help, relocation
services, consulting, marketing spend with advertising and media agencies, travel and facilities management, IT, and telecommunications and logistics, have become part of procurement’s responsibility in more progressive corporations.
6
S. A. Melnyk et al., Supply Chain Management 2010 and Beyond: Mapping the Future of the Strategic
Supply Chain (The Eli Broad College of Business at Michigan State University, 2006).
7
Leenders and Johnson, Major Changes in Supply Chain Responsibilities.
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20 Purchasing and Supply Management
Second, the growth of supply responsibilities can be seen in the span of supply chain
activities under purchasing or supply leadership. Recent additions include accounts payable, legal, training and recruiting, programs and customer bid support, and involvement
with new business development.
Third, growth can occur in the type of involvement of supply in what is acquired and
supply chain responsibilities. Clearly, on the lowest level, there is no supply involvement
at all. The next step up is a transactionary or documentary role. Next, professional involvement implies that supply personnel have the opportunity to exercise their expertise in
important acquisition process stages. At the highest level, meaningful involvement, a term
first coined by Dr. Ian Stuart, represents true team member status for supply at the executive table. Thus, in any major decision taken in the organization, the question “What are the
supply implications of this decision?” is as natural and standard as “What are the financial
implications of this decision?”
Fourth, supply can grow by its involvement in corporate activities from which it might
have been previously excluded. While involvement in make-or-buy decisions, economic
forecasts, countertrade, in- and outsourcing, and supplier conferences might be expected,
other activities such as strategic planning, mergers and acquisitions, visionary task
forces, and initial project planning might be good examples of broader corporate strategic
integration.
Each of these four areas of opportunity for growth allows for supply to spread its wings
and influence creation in organization and increase the value of its contributions.
Effective Contribution to Organizational Success
Ultimately, supply’s measure of its contribution needs to be seen in the success of the organization as a whole. Contributing operationally and strategically, directly and indirectly,
and in a positive mode, the challenge for supply is to be an effective team member. Meaningful involvement of supply can be demonstrated by the recognition accorded supply by
all members of the organization.
How happy are other corporate team members to have supply on their team? Do they
see supply’s role as critical to the team’s success? Thus, to gain not only senior management recognition but also the proper appreciation of peer managers in other functions is a
continuing challenge for both supply professionals and academics.
THE ORGANIZATION OF THIS TEXT
In this first chapter are listed the more common influences for all organizations. In subsequent chapters, we will cover various decisions regarding organizational and supply strategies, organization supply processes, make or buy, the variety of organizational needs,
and how to translate these into commercial equivalents. These will be followed by decisions on quality, quantity, delivery, price, and service—the traditional five value criteria—
culminating in supplier selection. Suppliers are located domestically and internationally
and their location will affect how supply should be managed. The legal and ethical framework for supply establishes the framework for the contract between these two parties. How
to evaluate supplier performance and how to relate to suppliers is followed by a section
on supply chain associated responsibilities which may or may not be part of the supply
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Chapter 1 Purchasing and Supply Management 21
manager’s assignment. This text concludes with the evaluation of the supply function, its
performance reporting, and current trends in the field.
Conclusion
If the chief executive officer and all members of the management team can say, “Because
of the kinds of suppliers we have and the way we relate to them, we can outperform our
competition and provide greater customer satisfaction,” then the supply function is contributing to its full potential.
This is the ambitious goal of this text: to provide insights for those who wish to understand the supply function better, whether or not they are or will be employed in supply
directly.
Questions
for
Review
and
Discussion
1. What is the profit-leverage effect of supply? Is it the same in all organizations?
2. “Supply is not profit making; instead, it is profit taking since it spends organizational
resources.” Do you agree?
3. What kinds of decisions does a typical supply manager make?
4. “In the long term, the success of any organization depends on its ability to create and
maintain a customer.” Do you agree? What does this have to do with purchasing and
supply management?
5. Is purchasing a profession? If not, why not? If yes, how will the profession, and the
people practicing it, change over the next decade?
6. Differentiate between purchasing, procurement, materials management, logistics,
supply management, and supply chain management.
7. In what ways might e-commerce influence the role of supply managers in their own
organizations? In managing supply chains or networks?
8. In the petroleum and coal products industry, the total purchase/sales ratio is 80 percent, while in the food industry it is about 60 percent. Explain what these numbers
mean. Of what significance is this number for a supply manager in a company in each
of these industries?
9. How does supply management affect return on assets (ROA)? In what specific ways
could you improve ROA through supply management?
10. How can the expectations of supply differ for private versus public organizations?
Services versus goods producers?
References
Cavinato, J. L.; A. E. Flynn; and R. G. Kauffman. The Supply Management Handbook.
7th ed. Burr Ridge, IL: McGraw-Hill/Irwin, 2007.
Lambert, D. M. Supply Chain Management: Processes, Partnerships and Performance,
Sarasota, Florida: Supply Chain Management Institute, 2004.
Leenders, M. R., and H. E. Fearon. “Developing Purchasing’s Foundation,” The Journal
of Supply Chain Management 44, no. 2 (2008), pp. 17–27.
Leenders, M. R., and A. E. Flynn. Value-Driven Purchasing: Managing the Key Steps in
the Acquisition Process. Burr Ridge, IL: Irwin Professional Publishing, 1995.
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22 Purchasing and Supply Management
Nelson, Dave; Patricia E. Moody; and Jonathan Stegner. The Purchasing Machine. New
York: The Free Press, 2001.
Rozemeijer, Frank. Creating Corporate Advantage in Purchasing. Eindhoven, The
Netherlands: Technische Universiteit Eindhoven, 2000.
Zheng, J.; L. Knight; C. Hartland; S. Humby; and K. James. “An Analysis of Research into
the Future of Purchasing and Supply Management.” Journal of Purchasing and Supply
Management 13, no. 1 (2007), pp. 69–83.
Case 1–1
Qmont Mining
Alice Winter, working on a summer internship at Qmont
Mining, was trying to determine how the supply systems
for remote locations could be improved.
QMONT MINING
Qmont Mining, a major metals producer with headquarters in Vancouver, British Columbia, had extensive holdings all over the Canadian North. Supply
management had been completely decentralized until
very recently. A consulting study had recommended a
move to more centralized supply management, including purchasing and logistics. The purchasing and stores
manager at Qmont’s largest mine in British Columbia,
Harry Davidson, had been asked to pursue this idea and
to make recommendations on potential improvements.
Harry had hired Alice Winter, a college student in logistics, to work as a summer intern to assist him. Harry
had said to Alice: “A good project for you to work on
is the way we handle supply for remote locations. I suspect that we could do substantially better, but I really
don’t have any hard data.”
REMOTE LOCATIONS
Alice found out that Qmont had 17 remote locations, ranging from three small mines that had a buyer/storekeeper
on site to two mine start-ups, nine exploration sites, and
three development projects with a distance of 5,000 km
between the farthest ones and 300 km between the closest ones. Qmont made a distinction between exploration
sites where the potential for ore was totally unproven to
joh77899_ch01_001-025.indd 22
development sites where the possibility of mineralization
had been proved, but where the extent of mineralization
had to be determined. Qmont used its own drilling crews
at these two types of sites, although most mining companies preferred to use contract drillers. Qmont managers believed that for security, availability, and cost reasons they
needed full control and in-house crews. Typically, at both
exploration and development sites an engineer or geologist
would be in charge. All supplies for these sites would be
flown in by bush planes on floats or by helicopters.
ACCOUNTING INFORMATION
Alice Winter decided to visit the accounting department at
Vancouver headquarters first to see what she could learn
about supply in remote locations. She found out that accounting paid all invoices from suppliers who claimed to
have supplied a remote location even when no confirmation of orders, deliveries, or receipts was available. This
occurred in about one-third of all invoices. The accountant explained: “Getting suppliers to provide odd requirements in a hurry and to get bush pilots to fly them in is a
constant hassle. The last thing we want to do is lose the
goodwill of these suppliers because we don’t have our records straight and delay payments.”
DEVELOPMENT AND EXPLORATION
SITE DATA
Alice did get the chance to review the previous year’s
actual supplier invoices for three different sites (one
development and two exploration) over a four-month
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Chapter 1 Purchasing and Supply Management 23
summer period. Communication between actual sites and
suppliers occurred in two main ways. Since site leaders were in regular contact via satellite with head office
personnel in exploration or engineering, they frequently
asked the head office contacts to place specific orders for
them. In addition, it was common for remote site personnel to contact suppliers directly and place orders. Moreover, when a drill needed a quick replacement part, apparently it was not unusual to place orders with several
suppliers at the same time in the hope that at least one
would deliver quickly. Drill and crew downtime was seen
as very expensive.
The site accounting records showed that the total supply spend for these three sites totaled about $850,000. Of
this total, approximately:
• $220,000 was for drilling equipment including drill
bits and rods.
• $120,000 for MRO suppliers.
• $420,000 for air transport covering seven different
suppliers, of which air transport of personnel in and
out of sites cost about $170,000.
• $180,000 for fuel.
• $80,000 for food.
Alice uncovered 22 instances of multiple deliveries
of the same item within days to the same site from different suppliers and 12 instances of multiple deliveries of
the same item from the same supplier within a few days.
There were 14 instances where the airfreight bill was at
least 10 times higher than the value of the item transported.
NEXT STEPS
After several weeks of gathering this information, Alice wondered what her next steps should be. One option
would be to gather similar information for all remote
sites to get a more complete picture and to extend the
time period. Another would be to get more specific
about the details of each order and each supplier. She
knew that she would be meeting with Harry Davidson in
a few days to discuss her progress and findings to date.
She also expected Harry to ask her what she believed she
should do next.
Case 1–2
Erica Carson
“We will do it for 10 percent less than what you are paying
right now.” Erica Carson, purchasing manager at Wesbank,
a large western financial institution, had agreed to meet
with Art Evans, a sales representative from D.Killoran
Inc., a printing supplier from which Wesbank currently
was not buying anything. Art Evans’s impromptu and unsolicited price quote concerned the printing and mailing of
checks from Wesbank.
Wesbank, well known for its active promotional efforts to attract consumer deposits, provided standard personalized consumer checks free of charge. Despite the
increasing popularity of Internet banking, the printing
of free checks and mailing to customers cost Wesbank
$8 million in the past year.
Erica Carson was purchasing manager in charge of
all printing for Wesbank and reported directly to the vice
president of supply.
It had been Erica’s decision to split the printing and
mailing of checks equally between two suppliers. During
joh77899_ch01_001-025.indd 23
the last five years, both suppliers had provided quick and
quality service, a vital concern of the bank. Almost all
checks were mailed directly to the consumer’s home or
business address by the suppliers. Because of the importance of check printing, Erica had requested a special cost
analysis study a year ago, with the cooperation of both
suppliers. The conclusion of this study had been that both
suppliers were receiving an adequate profit margin and
were efficient and cost-conscious and that the price structure was fair. Each supplier was on a two-year contract.
One supplier’s contract had been renewed eight months
ago; the other’s expired in another four months.
Erica believed that Killoran was underbidding to gain
part of the check-printing business. This in turn would
give Killoran access to Wesbank’s customers’ names.
Erica suspected that Killoran might then try to pursue
these customers more actively than the current two suppliers to sell special “scenic checks” that customers paid
for themselves.
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24 Purchasing and Supply Management
Case 1–3
Southeastern University
Heather Sloman, buyer in the purchasing department of
Southeastern University, was preparing for a meeting
with her boss, Glen Meredith, for later that day. Two
days earlier, on April 6, Glen had received a phone call
from Walter Charbonneau, manager of the university registrar’s office. Heather was surprised to learn from Glen
that Walter had just bought a new piece of equipment
for his department without following standard university
purchasing policies. Glen asked Heather to look into the
situation and get back to him with recommendations.
PURCHASING DEPARTMENT
Southeastern University was one of the largest universities in the state, with total enrollment of more than 25,000
graduate and undergraduate students and approximately
3,500 staff. There were 12 faculties at the university, over
20 continuing education diploma and certificate programs,
and three affiliated colleges. Purchasing was centralized,
and the purchasing director, Blake Hyatt, reported to the
university’s vice president of administration.
The purchasing department was responsible for negotiating with suppliers, signing contracts with suppliers,
and supervising the execution of contracts. Small-value
purchases, those less than $100, could be handled out of
petty cash. The purchasing department had also recently
introduced a purchasing card, which could be used to
acquire eligible goods and services with a value of less
than $1,000.
The purchasing process began when a purchase request was submitted to the purchasing department. A
clerk would stamp the requisition with the date and time
received and checked it for proper signing authority. In
some cases, it was necessary to forward the requisition
to the research accounting section in the department of
finance for account approval. Other information also was
added to the requisition, such as tax and duty status, product classification, and supplier status.
Although the purchase requisition form provided
an opportunity for the requisitioner to identify the preferred supplier, the policy was to solicit at least two written quotations for purchases in excess of $7,500 and a
minimum of three quotations for purchases in excess of
$15,000. One of the buyers would prepare a request for
joh77899_ch01_001-025.indd 24
quotation form (RFQ) and contacted approved suppliers. The RFQ form specified details, such as product or
service description, quantities, FOB point, and terms of
payment. Recent government legislation required that
any RFQs in excess of $100,000 had to be posted on
the Internet. After all bids were received and evaluated,
the buyer would select the supplier and issue a purchase
order.
The purchasing department maintained a list of approximately 1,200 approved suppliers, which was adjusted every three to five years. The selection criteria for
becoming an approved vendor was based on the following
weighted average evaluation system:
•
•
•
•
Price, 50 percent
Compliance with specifications, 25 percent
Service, 20 percent
Partnership, 5 percent
The purchasing department had three buying groups,
and each group handled approximately 20 requests each
day. (See Exhibit 1 for the organization chart.) In addition, approximately 250 contracts were rebid each year
for ongoing purchases, such as snow removal services
and photocopier supplies. The total dollar volume of
purchases amounted to $75 million of goods and services
each year.
According to Heather Sloman, the main objective of
the purchasing department was to achieve the greatest
cost savings. She commented on the role of purchasing
at the university: “Our training in purchasing allows us to
negotiate the best deals for the university and help avoid
wasting university money.”
Although it was university policy that approval from
the purchasing department was required before commitments could be made to suppliers, it was not unusual that
university personnel contacted suppliers directly. Every
year there were about 275 cases where contracts were
signed with suppliers without prior approval of purchasing. Heather described what happened in these situations:
“Most of the time, the only thing we can do is to call them
and ask them to provide the details of the purchase. Usually the purchase has already been made, and there isn’t
much else that can be done.”
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Chapter 1 Purchasing and Supply Management 25
EXHIBIT 1 Organization Chart of the Purchasing Department
Blake Hyatt
Director
Cindy Prosser
Administrative Assistant
Joan Kada
Senior Buyer
Maintenance Equipment
and Supplies
Edward Bell
Senior Buyer
Scientific Equipment
Glen Meredith
Senior Buyer
Computer and
Business Products
Ken McKellar
Buyer
Leslie Heyninck
Buyer
Heather Sloman
Buyer
Ray Sharen
Manager Purchasing
Systems
Elizabeth Robertson
Purchasing
Administrator
Barbara Hillman
Clerk
James Pryor
Central Supplies
THE FOLDING MACHINE ISSUE
HEATHER’S OPTIONS
The office of registrar handled about 160,000 pieces of
mail a year. There were four major peaks of mailings
each year: fees, admissions, records, and scholarships.
As many as 50 to 60 people could be occupied manually stuffing envelopes two days a month. A combination
of full-time employees and temporary staff was used to
perform this activity.
Walter Charbonneau had seen an advertisement in a
flyer for an automatic folding machine, which could be
used to eliminate some of the manual work in dealing
with mass mailings. He later contacted a representative
of the company and placed an order for the machine, at
a cost of $14,000. Glen was notified shortly after the
machine had arrived because Walter needed to make arrangements for payment. As far as Heather knew, the
machine had arrived only in the last few days and had
not been installed.
Heather found that the supplier of the folding machine was not on her approved supplier list. She then
contacted three of her suppliers and received quotes
of $10,000, $11,000, and $15,000 for similar equipment. The third quotation included one year of free
service.
Heather recognized that some employees were going to
ignore university policy from time to time and she had
to be prepared to deal with such situations. However, if
university staff failed to appreciate the benefits of sound
purchasing practices, the university’s centralized purchasing system would be undermined. When she spoke
to Glen Meredith about the situation two days earlier, he
said: “Let me know what we should do about this machine
in the registrar’s office. But also think about what else
we can be doing to prevent these kinds of situations from
happening again. These bad deals cost the university too
much money each year. Besides, as a public institution,
we must be extra careful to follow our procedures.”
There were a number of alternatives Heather was considering regarding the equipment. One option was to simply keep the machine and pay the supplier. However, she
felt the equipment could be returned, and if necessary she
could negotiate a cancelation penalty with the supplier.
Alternatively, Heather could go back to the supplier and
use the quotations to negotiate a lower price.
Heather had about four hours before her meeting with
Glen. As she sat down to prepare for the meeting, Heather
thought about what she might say to Glen regarding
avoiding future problems of this kind.
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Chapter Two
Supply Strategy
Chapter Outline
Levels of Strategic Planning
Major Challenges in Setting Supply
Objectives and Strategies
Strategic Planning in Supply
Management
Risk Management
Operational Risk: Supply Interruptions and
Delays
Financial Risk: Changes in Price
Reputational Risk
Managing Supply Risks
The Corporate Context
Strategic Components
What?
Quality?
How Much?
Who?
When?
What Price?
Where?
How?
Why?
Conclusion
Questions for Review and Discussion
References
Cases
2–1 Spartan Heat Exchangers Inc.
2–2 Sabor Inc.
2–3 Ford Motor Company: Aligned
Business Framework
26
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Chapter 2
Supply Strategy
27
Key Questions for the Supply Decision Maker
Should we
• Become more concerned about the balance sheet?
• Develop a strategic plan for purchasing and supply management?
• Spend a major part of our time on strategic, rather than operational, issues?
How can we
• Anticipate the professional changes we will face in the next 10 years?
• Ensure supply is included as part of the organization’s overall strategy?
• Generate the information needed to do strategic planning?
In strategic supply, the key question is: How can supply and the supply chain contribute
effectively to organizational objectives and strategy? The accompanying question is: How
can the organizational objectives and strategy properly reflect the contribution and opportunities offered in the supply chain?
A strategy is an action plan designed to achieve specific long-term goals and objectives.
The strategy should concentrate on the key factors necessary for success and the major
actions that should be taken now to ensure the future. It is the process of determining the
relationship of the organization to its environment, establishing long-term objectives, and
achieving the desired relationship(s) through efficient and effective allocation of resources.
LEVELS OF STRATEGIC PLANNING
To be successful, an organization must approach strategic planning on three levels:
1. Corporate. These are the decisions and plans that answer the questions of What business are we in? and How will we allocate our resources among these businesses? For
example, is a railroad in the business of running trains? Or is its business the movement
(creating time and space utility) of things and people?
2. Business Unit. These decisions mold the plans of a particular business unit, as necessary, to contribute to the corporate strategy.
3. Function. These plans concern the how of each functional area’s contribution to the
business strategy and involve the allocation of internal resources.
Several studies by CAPS Research reinforced the notion that linking supply strategy to
corporate strategy is essential, but many firms do not yet have mechanisms in place to link
the two.1
1
R. M. Monczka and K. J. Petersen, Supply Strategy Implementation: Current State and Future
Opportunities (Tempe, AZ: CAPS Research, 2008). Carter et al., Succeeding in a Dynamic World: Supply
Management in the Decade Ahead (Tempe, AZ: CAPS Research, 2007). P. F. Johnson and M. R. Leenders,
Supply’s Organizational Roles and Responsibilities (Tempe, AZ: CAPS Research, 2004).
joh77899_ch02_026-044.indd 27
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28 Purchasing and Supply Management
FIGURE 2–1
Supply
Strategy
Congruent with
Organizational
Strategy
FIGURE 2–2
Supply
Strategy
Links Current
and Future
Markets to
Current and
Future Needs
Supply
objectives
Organizational
objectives
Supply
strategy
Organizational
strategy
Current
needs
Future
needs
Current
markets
Future
markets
Effective contribution connotes more than just a response to a directive from top management. It also implies inputs to the strategic planning process so that organizational
objectives and strategies include supply opportunities and problems.
This is graphically shown in Figure 2–1 by the use of double arrows between supply
objectives and strategy and organizational objectives and strategy.
A different look at supply strategy is given in Figure 2–2. This shows an effective
supply strategy linking both current needs and current markets to future needs and future
markets.
One of the significant obstacles to the development of an effective supply strategy lies
in the difficulties inherent in translating organizational objectives into supply objectives.
For example, Tony Brown, senior vice-president of global sourcing at Ford Motor Company, was implementing a new supply strategy that he believed would improve performance in the areas of quality, technology, delivery, cost, and speed to market. However,
the company chairman and CEO William Clay Ford Jr. will be interested in issues such as
how the new supply strategy will improve earnings per share and create shareholder value.
(See the Ford Motor Company case at the end of the chapter.).
Normally, most organizational objectives can be summarized under four categories:
survival, growth, financial, and environmental. Survival is the most basic need of any organization. Growth can be expressed in a variety of ways. For example, growth could be
in size of the organization in terms of number of employees or assets or number of operating units, or number of countries in which the organization operates, or in market share.
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Chapter 2 Supply Strategy
29
Financial objectives could include total size of budget, surplus or profit, total revenue,
return on investment, return on assets, share price, earnings per share, or increases in each
of these or any combination. Environmental objectives include not only traditional environmental concerns like clean air, water, and earth but also objectives such as the contribution to and fit with values and ideals of the organization’s employees and customers, and
the laws and aspirations of the countries in which the organization operates. The notion of
good citizenship is embodied in this fourth objective.
Unfortunately, typical supply objectives normally are expressed in a totally different
language, such as quality and function, delivery, quantity, price, terms and conditions,
service, and so on.
MAJOR CHALLENGES IN SETTING SUPPLY OBJECTIVES
AND STRATEGIES
The first major challenge facing the supply manager is the effective interpretation of corporate objectives and supply objectives. For example, given the organization’s desire to
expand rapidly, is supply assurance more important than obtaining “rock bottom” prices?
The second challenge deals with the choice of the appropriate action plan or strategy to
achieve the desired objectives. For example, if supply assurance is vital, is it best accomplished by single or dual sourcing, or by making in-house?
The third challenge deals with the identification and feedback of supply issues to be integrated into organizational objectives and strategies. For example, because a new technology can be accessed early through supply efforts, how can this be exploited? The Spartan
Heat Exchangers case at the end of this chapter provides an illustration of how supply
should be integrated to corporate strategy. The changes in corporate strategy and objectives
at Spartan necessitate changes in supply strategy.
The development of a supply strategy requires that the supply manager be in tune with
the organization’s key objectives and strategies and also be capable of recognizing and
grasping opportunities. All three challenges require managerial and strategic skills of the
highest order, and the difficulties in meeting these challenges should not be minimized.
STRATEGIC PLANNING IN SUPPLY MANAGEMENT
Today, firms face the challenge of prospering in the face of highly competitive world markets. The ability to relate effectively to outside environments—social, economic, political,
legal, and technological—to anticipate changes, to adjust to changes, and to capitalize on
opportunities by formulating and executing strategic plans is a major factor in generating
future earnings and is critical to survival. Supply must be forward looking.
A supply strategy is a supply action plan designed to permit the achievement of selected
goals and objectives. If well developed, the strategy will link the firm to the environment as
part of the long-term planning process. An overall supply strategy is made up of substrategies that can be grouped together into six major categories:
1. Assurance-of-supply strategies. Designed to ensure that future supply needs are met
with emphasis on quality and quantity. Assurance-of-supply strategies must consider
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30 Purchasing and Supply Management
2.
3.
4.
5.
6.
changes in both demand and supply. (Much of the work in purchasing research
[see Chapter 13] is focused on providing the relevant information.)
Cost-reduction strategies. Designed to reduce the laid-down cost of what is acquired
or the total cost of acquisition and use—life-cycle cost. With changes in the environment and technology, alternatives may be available to reduce an organization’s overall
operating costs through changes in materials, sources, methods, and buyer–supplier
relationships.
Supply chain support strategies. Designed to maximize the likelihood that the considerable knowledge and capabilities of supply chain members are available to the buying
organization. For example, better communication systems are needed between buyers
and sellers to facilitate the timely notification of changes and to ensure that supply
inventories and production goals are consistent with the needs. Supply chain members
also need better relations for the communication needed to ensure higher quality and
better design.
Environmental-change strategies. Designed to anticipate and recognize shifts in the
total environment (economic, organizational, people, legal, governmental regulations
and controls, and systems availability) so that it can turn them to the long-term advantage of the buying organization.
Competitive-edge strategies. Designed to exploit market opportunities and organizational strengths to give the buying organization a significant competitive edge. In the
public sector, the term competitive edge usually may be interpreted to mean strong
performance in achieving program objectives.
Risk-management strategies. Whereas the various aspects of the previous five types of
strategies have been covered earlier in this text, the issue of risk management has not
yet been discussed. Therefore, this section will be expanded here, not to imply greater
importance, but to assure adequate coverage.
RISK MANAGEMENT
Every business decision involves risk, and supply is no exception. In financial instruments
a higher rate of return is supposed to compensate the investor or lender for the higher risk
exposure. Risks in the supply chain can be classified into three main categories: (1) operational: the risk of interruption of the flow of goods or services, (2) financial: the risk that the
price of the goods or services acquired will change significantly, and (3) reputational risk.
All three risks affect the survival, competitiveness, and bottom line of the organization
and may occur simultaneously.
Operational Risk: Supply Interruptions and Delays
Every business continuity plan recognizes that supply interruptions and delays may occur.
Catastrophic events such as earthquakes, tornadoes, hurricanes, war, floods, or fire may
totally disable a vital supplier. Strikes may vary in length, and even short-term interruptions related to weather, accidents on key roads, or any other short-term factor affecting
the supply and/or transport of requirements may affect a buying organization’s capability
to provide good customer service.
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Chapter 2 Supply Strategy
31
A distinction can be drawn between factors beyond the purchaser’s or supplier’s control, such as weather, and those that deal directly with the supplier’s capability of selecting
its own suppliers, managing internally, and its distribution so as to prevent the potential
of physical supply interruption. Careful supplier evaluation before committing to purchase
can mitigate against the latter type of supply interruption. In situations of ongoing supply relationships, communication with key suppliers is essential. Such is the situation in
the Sabor case at the end of the chapter. Ray Soles is concerned about the potential shortage of a key raw material and must come to an agreement with his suppliers to avoid possible supply disruptions.
Unfortunately, supply interruptions increase costs. If last-minute substitutions need to
be made, these are likely to be expensive. Idle labor and equipment, missed customer delivery promises, and scrambling—all have increased costs associated with them.
Financial Risk: Changes in Price
Quite different from supply interruptions are those risks directly associated with changes in
the price of the good or service purchased. A simple example comes from the commodity
markets. Increases in the price of oil affect prices paid for fuel, energy, and those products
or services that require oil as a key ingredient or raw material.
A purchaser who has committed to a fixed-price contract may find a competitor able to
compete because commodity prices have dropped. Currency exchange rate changes and the
threat of shortages or supply interruption also will affect prices, as will arbitrary supplier
pricing decisions. Changes in taxation, tolls, fees, duties, and tariffs also will affect cost
of ownership.
Given that both supply interruption and price/cost risks directly impact any organization’s ability to meet its own goals and execute its strategies, supply chain risks—whether
they are on the supply side, internal to the organization, or on the customer side—need to
be managed properly.
Reputational Risk
Reputational risk may be even more serious than operational or price risks, because the loss
of reputation may be catastrophic for a company. Both legal and ethical supply issues may
affect the company’s reputation. “You are known by the company you keep” applies not
only to one’s personal life, but also to corporate life. Thus, the reputation of a company’s
supply chain members will affect its own image. The internal and external communications
decisions and behavior of supply personnel can have both negative and positive impacts.
Therefore, the content of the legal issues and ethics (Chapter 15) is highly relevant to reputational risk. Adverse publicity with respect to bribery, kickbacks, improper quality, improper disposal and environmental practices, dealings with unethical suppliers, and so on,
can be extremely damaging.
Managing Supply Risks
Managing supply risks requires (1) identification and classification of the risks, (2) impact
assessment, and (3) a risk strategy.
Given that supply is becoming more and more global and supply networks more
complex, risk identification is also becoming more difficult. The preceding discussion
identifying supply interruption and price/cost changes as two categories has been highly
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32 Purchasing and Supply Management
simplified. Technology, social, political, and environmental factors have not even been
mentioned yet. Technology has the potential of interrupting supply through the failure of
systems and through obsoleting existing equipment, products, or services, or drastically
changing the existing cost/price realities. A purchaser committed to a long-term, fixedprice contract for a particular requirement may find a competitor can gain a significant
advantage through a technology-driven, lower-cost substitute. Environmental legislative
changes can drastically offset a supplier’s capability to deliver at the expected price or to
deliver at all.
Because the well-informed supply manager is probably in the best position to identify
the various supply risks his or her organization faces, such risk identification should be
a standard requirement of the job, including the estimation of the probability of event
occurrence.
Impact assessment requires the ability to assess the consequences of supply interruption and/or price/cost exposure. Correct impact assessment is likely to require the input of
others in the organization, such as operations, marketing, accounting, and finance, to name
just a few. Assessed potential impact from identified risk may be low, medium, or high.
Combining potential impact assessment with the probability of event exposure creates
a table of risks with low probability and low impact on one extreme and high probability
with high impact on the other.
Obviously, high-impact, high-probability risks need to be addressed or, better yet,
avoided, if at all possible.
Managing supply risks should be started at the supply level, but may escalate to the
overall corporate level. Relatively simple actions such as avoiding high-risk suppliers or
high-risk geographical locations, dual or triple sourcing, carrying safety stock, hedging,
and using longer-term and/or fixed- or declining-price contracts and protective contract
clauses have been a standard part of the procurement arsenal for a long time. If most purchasers had their way, they would like to transfer all risk to their suppliers! However, the
assumption of risk carries a price tag, and a supplier should be asked to shoulder the risk if
it is advantageous to both the supplier and purchaser to do so.
The Corporate Context
Supply risk is only one of the various risks to which any organization is exposed. Traditionally, financial risks have been the responsibility of finance, property insurance part of
real estate, and so on. The emergence of a corporate risk management group headed by a
risk manager or chief risk officer (CRO) allows companies as a whole to assess their total
risk exposure and seek the best ways of managing all risks.
A supply manager’s decision not to source in a politically unstable country because of
his or her fear of supply interruption may also miss an opportunity to source at a highly advantageous price. A corporate perspective might show that the trade-off between a higher
price elsewhere and the risk of nonsupply favors the apparently riskier option. Mergers
and acquisitions as well as insourcing and outsourcing represent phenomena full of opportunities and risks in which supply input is vital to effective corporate risk resolution.
The decision about how much risk any organization should be willing to bear and whether
it should self-insure or seek third-party protection is well beyond the scope of this text.
Nevertheless, it is clear that risk management is going to be an area of growing concern
for supply managers.
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Chapter 2 Supply Strategy
FIGURE 2–3
Strategic
Supply
Planning
Process
33
Restate
organizational goals
Identify and
analyze alternatives
Determine supply
objectives to contribute
to organizational goals
Isolate factors affecting
achievement of
supply objectives
Determine
supply
strategy
Review implementation
factors
Gain commitment
and implement
Evaluate
Figure 2–3 is a conceptual flow diagram of the strategic supply planning process. It
is important to recognize that the planning process normally focuses on long-run opportunities and not primarily on immediate problems.
STRATEGIC COMPONENTS
The number of specific strategic opportunities that might be addressed in formulating an overall supply strategy is limited only by the imagination of the supply manager. Any strategy chosen should include a determination of what, quality, how much,
who, when, what price, where, how, and why. Each of these will be discussed further.
(See Figure 2–4.)
What?
Probably the most fundamental question facing an organization under the “what” category
is the issue of make or buy, insourcing, and outsourcing. Presumably, strong acquisition
strengths would favor a buy strategy. (See Chapter 5.)
Also included under the heading of what is to be acquired is the issue of whether the
organization will acquire standard items and materials readily available in the market, as
opposed to special, custom-specified requirements. Standard items may be readily acquired
in the marketplace, but they may not afford the organization the competitive edge that
special requirements might provide.
joh77899_ch02_026-044.indd 33
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34 Purchasing and Supply Management
FIGURE 2–4
Supply
Strategy
Questions
1. What?
Make or buy
Standard versus special
2. Quality?
Quality versus cost
Supplier involvement
3. How Much?
Large versus small quantities (inventory)
4. Who?
Centralize or decentralize
Quality of staff
Top management involvement
5. When?
Now versus later
Blank check system
Forward buy
6. What Price?
Premium
Standard
Lower
Cost-based
Market-based
Lease/make/buy
7. Where?
Local, regional
Domestic, international
Large versus small
Single versus multiple source
High versus low supplier turnover
Supplier relations
Supplier certification
Supplier ownership
8. How?
Systems and procedures
Computerization
Negotiations
Competitive bids
Fixed bids
Blanket orders/open orders
Systems contracting
Blank check system
Group buying
Materials requirements planning
Long-term contracts
Ethics
Aggressive or passive
Purchasing research
Value analysis
9. Why?
Objectives congruent
Market reasons
Internal reasons
1. Outside supply
2. Inside supply
Quality?
Part of the “what” question deals with the quality of the items or services to be acquired.
Chapter 5 addresses the various trade-offs possible under quality. The intent is to achieve
continuous process and product or service improvement.
Supplier Quality Assurance Programs
Many firms have concluded that a more consistent quality of end-product output is absolutely essential to the maintenance of, or growth in, market share. Suppliers must deliver
consistent quality materials, parts, and components; this also will effect a marked reduction
in production costs and in-house quality control administrative costs. Therefore, a strategy
of developing suppliers’ knowledge of quality requirements and assisting them in implementation of programs to achieve desired results may be needed. Three of the programs
that might be used are:
1. Zero defect (ZD) plans. “Do it right the first time” is far more cost effective than making corrections after the fact.
2. Process quality control programs. These use statistical control charts to monitor various production processes to isolate developing problems and make needed adjustments
joh77899_ch02_026-044.indd 34
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Chapter 2 Supply Strategy
35
(corrections) before bad product is produced. The buying firm may need to assist the
supplier with the introduction of the needed statistical techniques.
3. Quality certification programs. Here the supplier agrees to perform the agreed-upon
quality tests and supply the test data, with the shipment, to the buying firm. If the seller
does the requisite outgoing quality checks and can be depended on to do them correctly,
the buying firm then can eliminate its incoming inspection procedures and attendant
costs. This approach almost always is a key element in any just-in-time purchasing
system, as discussed in the following section.
How Much?
Another major component of any supply strategy deals with the question of how much is
to be acquired in total and per delivery. Chapter 8 discussed a number of trade-offs possible under quantity. In JIT and MRP, the trend has been toward smaller quantities to be
delivered as needed, as opposed to the former stance of buying large quantities at a time to
ensure better prices. Ideally, buyers and suppliers try to identify and eliminate the causes of
uncertainty in the supply chain that drive the need for inventory, thus reducing the amount
of inventory in the total system. One option available under the how much question may
involve the shifting of inventory ownership.
The supplier maintains finished goods inventory because the supplier may be supplying a common item to several customers. The safety stock required to service a group of
customers may be much less than the combined total of the safety stocks if the several
customers were to manage their own inventories separately. This concept is integral to the
successful implementation of systems contracting (discussed in Chapter 4).
From a strategic standpoint, supply may wish to analyze its inventory position on all
of its major items, with a view to working out an arrangement with key suppliers whereby
they agree to maintain the inventory, physically and financially, with delivery as required.
Ideally, of course, the intent of both buyer and supplier should be to take inventory out
of the system. An area in the buyer’s facility may even be placed under the supplier’s
control.
Dell is one example of a company that has successfully used its supply relationships
to create a competitive advantage. Critical to Dell’s success is that it carries almost no
inventories, either finished products or materials, and everything that Dell buys from its
suppliers is immediately assembled into a computer and sold.2
Other options are to switch to JIT purchasing or to consignment buying. If a supplier
can be depended on to deliver needed purchased items, of the agreed-upon quality, in small
quantities, and at the specified time, the buying firm can substantially reduce its investment
in purchased inventories, enjoy needed continuity of supply, and reduce its receiving and
incoming inspection costs. To accomplish this requires a long-term plan and substantial
cooperation and understanding between buyer and seller.
In consignment buying, a supplier owns inventory in the buyer’s facility under the
buyer’s control. The buyer assumes responsibility for accounting for withdrawals of stock
from that consignment inventory, payment for quantities used, and notification to the supplier of the need to replenish inventory. Verification of quantities remaining in inventory
2
B. S. Fugate and J. T. Mentzer, “Dell’s Supply Chain DNA,” Supply Chain Management Review 8, no. 7
(2004), pp. 20–24.
joh77899_ch02_026-044.indd 35
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36 Purchasing and Supply Management
then would be done jointly, at periodic intervals. This strategy has advantages for both
supplier (assured volume) and buyer (reduced inventory investment) and is often used in
the distribution industry.
Who?
The whole question of who should do the buying and how to organize the supply function
has been addressed in Chapter 3. The key decisions are whether the supply function should
be centralized or not, what the quality of staff should be, and to what extent top management and other functions will be involved in the total acquisition process. To what extent
will teams be used to arrive at supply strategies?
When?
The question of when to buy is tied very closely to the one of how much. The obvious
choices are now versus later. The key strategy issue really lies with the question of forward
buying and inventory policy. In the area of commodities, the opportunity exists to go into
the futures market and use hedging. The organized commodity exchanges present an opportunity to offset transactions in the spot and future markets to avoid some of the risk of
substantial price fluctuation as discussed in Chapter 10.
What Price?
It is possible for any organization to follow some specific price strategies. This topic already has been extensively discussed in Chapter 11. Key trade-offs may be whether the
organization intends to pursue paying a premium price in return for exceptional service
and other commitments from the supplier, a standard price target in line with the rest of
the market, or a low price intended to give a cost advantage. Furthermore, the pursuit of a
cost-based strategy as opposed to a market-based strategy may require extensive use of
tools such as value analysis, cost analysis, and negotiation. For capital assets, the choice
of lease or own presents strategic alternatives, as discussed in Chapter 16.
Where?
Several possibilities present themselves under the question of where to buy. Many of these
are discussed in Chapter 12 under “Source Selection.” Obvious trade-offs include local,
regional, domestic, or international sourcing; buying from small versus large suppliers;
single versus multiple sourcing; and low versus high supplier turnover, as well as supplier
certification and supplier ownership. Lastly, through reverse marketing or supplier development, the purchaser may create rather than select suppliers.
How?
A large array of options exists under the heading of “how to buy.” These include, but certainly
are not limited to, supply chain management integration systems and procedures; choice of
technology; e-commerce applications; use of various types of teams; use of negotiations,
auctions, competitive bids, blanket orders, and open order systems; systems contracting;
group buying; long-term contracts; the ethics of acquisition; aggressive or passive buying;
the use of purchasing research and value analysis; quality assurance programs; and reduction of the supply base. Most of these will be discussed in Chapters 3 through 12 in this text.
joh77899_ch02_026-044.indd 36
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Chapter 2 Supply Strategy
37
Why?
Every strategy needs to be examined not only for its various optional components, but also
for the reason why it should be pursued. The normal reason for a strategy in supply is to
make supply objectives congruent with overall organizational objectives and strategies at
both an operational and strategic level. Other reasons may include market conditions, both
current and future. Furthermore, there may be reasons internal to the organization, both
outside of supply and inside supply, to pursue certain strategies. For example, a strong
engineering department may afford an opportunity to pursue a strategy based on specially
engineered requirements. The availability of excess funds may afford an opportunity to
acquire a supplier through backward/vertical integration. The reasons inside supply may
be related to the capability and availability of supply personnel. A highly trained and effective supply group can pursue much more aggressive strategies than one less qualified.
Other reasons may include the environment. For example, government regulations and
controls in product liability and environmental protection may require the pursuit of certain
strategies.
What makes supply strategy such an exciting area for exploration is the combination
of the multitude of strategic options coupled with the size of potential impact on corporate
success. The combination of sound supply expertise with creative thinking and full understanding of corporate objectives and strategies can uncover strategic opportunities of a size
and impact not available elsewhere in the organization.
Conclusion
The increasing interest in supply strategies and their potential contribution to organizational objectives and strategies is one of the exciting developments in the whole field
of supply. Fortunately, as this chapter indicates, the number of strategic options open to
any supply manager is almost endless. A significant difficulty may exist in making these
strategies congruent with those of the organization as a whole. The long-term perspective
required for effective supply strategy development will force supply managers to concentrate more on the future. The coming decade should be a highly rewarding one for those
supply managers willing to accept the challenge of realizing the full potential of supply’s
contribution to organizational success.
Questions
for
Review
and
Discussion
1. What role can (should) supply play in determining a firm’s strategy in the area of
social issues and trends?
2. How can the supply manager determine which cost-reduction strategies to pursue?
3. Can you have a supply strategy in public procurement? Why or why not?
4. Why should a supply manager consider hiring (or obtaining internally) an employee
without any supply background?
5. What can supply do to assist in minimizing a firm’s risk of product liability lawsuits?
6. What factors have caused the current interest in, and attention to, strategic purchasing
and supply planning?
joh77899_ch02_026-044.indd 37
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38 Purchasing and Supply Management
7. What type of data would supply need to contribute to an organization’s strategic
growth? How might supply obtain such data?
8. How can supply sell itself more effectively internally?
9. What do you believe to be the most difficult obstacles to making a supply function
strategic?
10. Why should supply be concerned about the balance sheet?
References
joh77899_ch02_026-044.indd 38
Carter, P. L.; R. M. Monczka; G. L. Ragatz; and P. L. Jennings. Supply Chain Integration:
Challenges and Good Practices. Tempe, AZ: CAPS Research, 2009.
Carter, P. L. et al. Succeeding in a Dynamic World: Supply Management in the Decade
Ahead. Tempe, AZ: CAPS Research, 2007.
Cavinato, J. L. “Supply Chain Logistics Risks: From the Back Room to the Board Room.”
International Journal of Physical Distribution & Logistics Management 34, no. 5
(2004), pp. 383–387.
Christopher, M.; H. Peck; and D. Towill. “A Taxonomy for Selecting Global Supply
Chain Strategies.” International Journal of Logistics Management 17, no. 2 (2006),
pp. 277–287.
Cox, A. Strategic Sourcing. Warwickshire, UK: Earlsgate Press, 2008.
Fawcett, S. E.; G. M. Magnan; and J. Ogden. Achieving World-Class Supply Chain
Collaboration: Managing the Transformation. Tempe, AZ: CAPS Research, 2007.
Fine, C. H. Clock Speed. Reading, MA: Perseus Books, 1998.
Hunt, S. D., and D. F. Davis, “Grounding Supply Chain Management in ResourceAdvantage Theory.” The Journal of Supply Chain Management 44, no. 1, pp. 10–21.
Johnson, P. F., and M. R. Leenders. Supply’s Organizational Roles and Responsibilities.
Tempe, AZ: CAPS Research, 2004.
Johnson, P. F., and M. R. Leenders. “Minding the Supply Savings Gaps.” MIT Sloan
Management Review 51, no. 2 (2010), pp. 25–31.
Johnson, P. F., and M. R. Leenders. Supply Leadership Changes. Tempe, AZ: CAPS
Research, March 2007, 106 pages.
Lambert, D. M. Supply Chain Management: Processes, Partnerships and Performance.
Sarasota, Florida: Supply Chain Management Institute, 2004.
Mol, M. J. “Purchasing’s Strategic Relevance.” Journal of Purchasing & Supply
Management 9, no. 1 (2003), pp. 43–50.
Monczka, R. M. and K. J. Petersen. Supply Strategy Implementation: Current State and
Future Opportunities. Tempe, AZ: CAPS Research, 2008.
Zsidisin, G. A.; G. L. Ragatz; and S. A. Melnyk. “The Dark Side of Supply Chain
Management.” Supply Chain Management Review 9, no. 2 (2005), pp. 46–52.
6/9/10 9:10 PM
Chapter 2 Supply Strategy
39
Case 2–1
Spartan Heat Exchangers Inc.
On June 10, Rick Coyne, materials manager at Spartan
Heat Exchangers Inc. (Spartan), in Springfield, Missouri,
received a call from Max Brisco, vice president of manufacturing: “What can the materials department do to facilitate Spartan’s new business strategy? I’ll need your
plan next week.”
SPARTAN HEAT EXCHANGERS
Spartan was a leading designer and manufacturer of specialized industrial heat transfer equipment. Its customers
operated in a number of industries, such as steel, aluminum smelting, hydro electricity generation, pulp and paper, refining, and petrochemical. The company’s primary
products included transformer coolers, motor and generator coolers, hydro generator coolers, air-cooled heat
exchangers, and transformer oil coolers. Spartan’s combination of fin-tube and time-proven heat exchanger designs had gained wide recognition both in North America
and internationally.
Sales revenues were $25 million and Spartan operated in a 125,000-square-foot plant. Spartan was owned
by Krimmer Industries, a large privately held corporation
with more than 10,000 employees worldwide, headquartered in Denver.
Rick Coyne summarized the business strategy of Spartan during the past 10 years: “We were willing to do anything for every customer with respect to their heat transfer
requirements. We were willing to do trial and error on the
shop floor and provide a customer with his or her own
unique heat transfer products.” He added, “Our design
and manufacturing people derived greatest satisfaction
making new customized heat transfer products. Designing and research capabilities gave us the edge in developing and manufacturing any kind of heat transfer product
required by the customer. Ten years ago, we were one of
the very few companies in our industry offering customized services in design and manufacturing and this strategy made business sense, as the customers were willing to
pay a premium for customized products.”
MANUFACTURING PROCESS
The customized nature of Spartan’s product line was supported by a job shop manufacturing operation with several
departments, each of which produced particular component
joh77899_ch02_026-044.indd 39
parts, feeding a final assembly area. Each job moved from
work center to work center, accompanied by a bill of material and engineering drawing. The first process involved fitting a liner tube (in which the fluid to be cooled passed) into
a base tube. This base tube, made of aluminum, was then
pressure bonded to the inner liner tube through a rotary extrusion process that formed spiral fins on the base tube. The
depth of the fins and the distance between them determined
the amount of airflow across the tubes, and thus the cooling
efficiency and power of the unit.
After the tubes were formed, cabinet and end plate fabrication began. The tubes were welded to the cabinet and
the end plates. Flanges were then welded to pairs of tubes
on the other side of the end plates to create a looped system. The unit was then painted and fans and motors were
installed. Finally, the unit was tested for leaks and performance, crated, and shipped to the job site for installation.
MATERIALS DEPARTMENT
Spartan’s buyers sourced all raw material and components required by manufacturing and were responsible for
planning, procurement, and management of inventories.
Rick managed an in-house warehouse used for housing the raw material inventories, maintained adequate
buffer inventories, and executed purchase contracts with
vendors, ensuring specifications were met while achieving the best possible price. Rick’s department included
two buyers, a material control clerk, an expediter, and two
shippers-receivers.
It was common for Spartan to have multiple vendors
for raw material supply, and the materials group used more
than 350 vendors for its raw materials, with current lead
times ranging from a few days to six weeks. This wide supplier base was necessitated by the customization strategy
adopted by the company. Rick noted that approximately
35 percent of Spartan’s purchases were for aluminum
products, mainly tubes and sheets. On average the plant
had $3.5 million worth of inventory, in the form of both
raw and work in process. Raw material inventory constituted approximately 40 percent of the total. Rick estimated
that Spartan had inventory turns of four times per year,
which he believed was comparable to the competition.
Manufacturing operations regularly complained about
material shortages and stockouts, and regular inventory audits
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40 Purchasing and Supply Management
indicated significant discrepancies with inventory records on
the company’s computer system. Furthermore, a significant
amount of stock was written off each year due to obsolescence. Rick suspected that production staff regularly removed stock without proper documentation and that workers
frequently deviated from established bills of material.
NEW BUSINESS STRATEGY
Competition in the heat exchanger industry had increased
dramatically over the past decade, with much of the new
competition coming from Korea and Europe. Korean
firms, with their low cost base, competed primarily on
price, while European firms focused on standardizing their
product lines to a few high-volume products and competed
on delivery lead time and price. Spartan’s competitors
in Europe used assembly-line manufacturing processes,
rather than batch or job shop operations.
Senior management viewed the competition from
Europe and Korea as an imminent threat. Many of Spartan’s customers had recently developed aggressive expectations regarding pricing and delivery lead times, and
some key customers had decided to opt for standard product design, sacrificing custom design for lower cost and
faster delivery.
The changing nature of the industry forced senior management to reexamine their business strategy. As a result,
in January, a multidiscipline task force representing engineering, manufacturing, and sales was formed with the
mandate to formulate a new five-year business strategy.
The new corporate strategy was finalized in May and
reviewed with the management group on June 1st in an
all-day staff meeting. The central theme of the new strategy was standardization of all product lines, in terms of
both design and manufacturing, reducing variety to three
or four basic lines for each product category. The sales
department would no longer accept orders for specialized
designs. The aim of the new strategy was to reduce the
delivery lead time from 14 weeks to 6 weeks and to lower
production costs dramatically.
NEW CHALLENGES FOR MATERIAL
DEPARTMENT
Max Brisco indicated that he expected the materials group
to play a major role in support of the new corporate strategy
and needed to know by next week the specifics of Rick’s
plan. The task force had set a number of ambitious targets.
First, customer lead times for finished products were to be
reduced to six weeks from the current average of 14 weeks.
Second, the new objective for inventory turns was 20 times.
Meanwhile, raw material stockouts were to be eliminated.
Third, Max believed that product standardization also
would provide opportunities to reduce costs for purchased
goods. He expected that costs for raw materials and components could be cut by 10 percent over the next 12 months.
Rick fully supported the new direction that the company was taking and saw this as an opportunity to make
major changes. He knew that Max would want the specifics of his plan during the meeting in a week’s time.
Case 2–2
Sabor Inc.
In mid-April, Ray Soles, vice president of supply chain
management at Sabor Inc., had become increasingly concerned about the potential shortage of supply of marconil, a new high-tech raw material for air filtration. Sabor
Inc.’s three suppliers, during the last two weeks, had advised Ray Soles to sign long-term contracts and he was
trying to assess the advisability of such commitments.
SABOR INC.
Sabor Inc. of Cleveland, Ohio, produced high-quality
consumer and industrial air-conditioning and heating units. An extensive network of independent and
company-owned installation and sales centers serviced
joh77899_ch02_026-044.indd 40
customers throughout the North American market. Total
company sales last year totaled $800 million.
AIR FILTRATION AND MARCONIL
Sabor Inc. for decades had sold air humidification and
air filtration units along with its prime units in air heating and cooling. Until three years ago, air filtration had
accounted for about 7 percent of total corporate sales and
had been sold primarily as add-ons to a new air cooling/
heating system. However, with the advent of marconil,
air filtration had started to increase significantly as a percentage of total sales. Marconil, a new high-tech product
developed as part of the U.S. space effort, had a range of
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Chapter 2 Supply Strategy
unique properties of high interest to a variety of industries. In the case of air filtration, when processed by a Sabor Inc. developed and patented process, marconil could
be transformed into a thin, very light, and extremely fine
meshlike sponge material capable of filtering extremely
small particles.
Given the population’s sensitivity to air quality and the
increasing number of people with asthma and allergies,
the new Sabor filters became popular, not only with new
Sabor air system installations but also as retrofits in older
air conditioning and heating systems. Moreover, compared to electronic air cleaners that cost about three times
as much to install and required monthly cleaning, marconil filters had to be replaced every six months, guaranteeing a continued sales volume of filters for years to come.
When combined with an ultraviolet light unit, which
killed airborne bacteria, a marconil air cleaning system
was considered a huge leap forward in air treatment.
The manufacturing cost of a marconil filter accounted
for about 28 percent of its selling price.
AIR FILTRATION SALES
Along with the marconil filtration system introduction
three years ago, Sabor’s marketing department had initiated a significant promotional campaign directed at both
the industrial and consumer sectors. Marketing’s ability to
forecast sales accurately had not been impressive, according to Ray Soles. For the first year, marketing had forecast
marconil filter sales at $1 million, when in reality they
sold $11 million. In the second year, the forecast was for
$15 million and actual sales were $29 million, and, in the
third year, a forecast of $40 million turned into actual sales
of $72 million. The marketing department expected sales
growth to level off over the next three years to a rate of
20 percent per year.
EXHIBIT 1
Sabor
Marconil
Purchases and
Prices
Company
Bilt Chemical
Warton Inc.
G. K. Specialties
Prices
joh77899_ch02_026-044.indd 41
MARCONIL SUPPLY
Sabor’s first marconil supplier was Bilt Chemical, a
longtime supplier of paints and adhesives to Sabor and a
large, diversified, innovative chemical producer that held
the patent on marconil. Ray Soles did not like the idea
of single sourcing and, therefore, when marconil requirements rose significantly in the second year, he brought
in a second supplier, Warton Inc., which not only produced the marconil raw materials (under license from Bilt
Chemical), but also manufactured a variety of marconil
products in the textile and automotive fields. In the third
year, Ray had secured a third supplier, G. K. Specialties,
a much smaller company than Bilt Chemical and Warton
Inc., which also produced marconil under license for its
own applications in aerospace and the military, but which
had some excess capacity that it sold on the open market.
All three suppliers sold marconil at identical prices,
which had increased over the past three years. Actual
volumes purchased by Sabor Inc. from each of the three
suppliers were as shown in Exhibit 1. The current price of
marconil from all three suppliers was $50.00.
SUPPLIER PROPOSALS FOR LONGTERM CONTRACTS
During the first two weeks of April, Ray Soles was visited
by each of his current three marconil suppliers with Bilt
Chemical first. Each warned that a shortage of marconil
supply was looming and that unless Ray was willing to
sign a long-term contract, they would not be in a position
to guarantee supply. However, each proposal was different.
Bilt Chemical proposed a five-year contract with takeor-pay commitments of 25,000 pounds for the current
year and 20 percent annual increases in volume for each
of the following years. Prices were subject to escalation
Capacity
(in pounds)
80,000
40,000
20,000
41
Purchases
(in pounds)
Year 1
Year 2
Year 3
5,000
0
0
$39.00
10,000
3,000
20,000
8,000
4,000
$44.00
$42.00
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42 Purchasing and Supply Management
for energy, raw material, and labor every quarter based on
the current $50.00 price per pound.
Warton Inc. proposed a two-year contract for 10,000
pounds each year with similar price provisions to those
of Bilt Chemical.
G. K. Specialties suggested an agreement for 12.5 percent of Sabor’s annual requirements, which could be
dropped at any time by either party, but which proposed a
price of $56.00 for the current year, to be adjusted semiannually, thereafter based on inflation, energy, labor, and
material.
Although Ray Soles did not know much about the
actual manufacturing process for marconil, he had heard
that increases in capacity were expensive. He also understood that two of the three component raw materials for
marconil were by-products from industrial processes that
were reasonably stable.
Since Ray Soles had been able to buy almost all of
Sabor’s needs on quarterly, semiannual, or annual contracts, he was not particularly keen on departing from his
current supply practice. He had heard some rumors that
in a few years a much lower-cost substitute for marconil
might be developed. He suspected that, therefore, his current suppliers were anxious to tie Sabor to a long-term
commitment.
APRIL 15
On April 15, the Bilt Chemical sales representative sent
an e-mail to Ray Soles requesting a meeting on April 22.
The e-mail concluded, “I would like to bring my sales
manager so that we may discuss our proposal for the
marconil with you. We will not be able to guarantee you
supply after August 1, if you are unable to commit.”
Case 2–3
Ford Motor Company: Aligned Business Framework3
Tony Brown, senior vice president of global sourcing
at Ford Motor Company (Ford), was putting the finishing touches on his plan for the company’s new supply
chain strategy—“Aligned Business Framework” (ABF).
ABF was a bold step that would significantly change in
the relationships between Ford and its suppliers. Tony
described his motivation: “We want to operate a supply
chain management system that delivers on the dimensions of quality, technology, delivery and cost, while
executing programs in a disciplined fashion with faster
time-to-market.”4
It was August 10, 2005, and Tony was expected to review the final details of his proposal with company chairman and CEO William Clay (Bill) Ford Jr. before making
a formal public announcement the following month. ABF
would substantially reduce the number of suppliers and give
those that remained long-term contracts and early involvement in new product development programs. Tony expected
that the strategy would provide benefits to Ford through
overall lower costs, while suppliers would benefit from
long-term financial stability and profitability. The question
remained, however, how he would convince Ford’s supplier
community to commit to the principles of ABF.
FORD MOTOR COMPANY
Founded in 1903, Ford was the no. 2 U.S. automaker with
global sales of approximately $177 billion. In 2005, its
global brands included Ford, Lincoln, Mercury, Jaguar,
Land Rover, Aston Martin, and Volvo.5 In recent years all
of the “Detroit 3” (General Motors, Ford, and Chrysler)
automakers were struggling under intense global competition, rising fuel prices, and steep product discounts
and rebates. In the most recent quarter, Ford reported a
$1.1 billion operating loss and the company’s debt had
recently been downgraded to junk-bond status. To turn
around company performance, Ford had announced plans
to cut its salaried workforce, reduce capacity by closing
plants and selling the Hertz rental car division, and ramp
up production of hybrid vehicles.6
3
This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented
in this case are not necessarily those of Ford Motor Company or any of its employees.
4
Tom Stundza, “Ford Has a Better Idea,” Purchasing 135, no. 12 (2006), p. 49.
5
Ford Motor Company 2005 annual report.
6
Jeffrey McCracken, “Ford Retools: Seeks Big Savings by Shaking Up Parts Supply System,” The Globe & Mail, September 29,
2005, p. B19.
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Chapter 2 Supply Strategy
ALIGNED BUSINESS
FRAMEWORK (ABF)
The Ford global supply chain included approximately
2,500 production and 9,000 nonproduction suppliers, with
operations in more than 60 countries, supporting 107 Ford
manufacturing sites. Total purchases in 2005 were more
than $90 billion for roughly 250 production commodities (e.g., seats, heating and cooling systems, advanced
electronics and steering systems) and 500 nonproduction commodities (e.g., health care, software, logistics,
and marketing and advertising services). The more than
130,000 active production parts accounted for approximately $70 billion of total annual purchases.7
Historically Ford leaned heavily on suppliers for
annual across-the-board price reductions that averaged
approximately 3 percent, although requests for more
substantial reductions were commonplace. This environment had created contemptuous relationships between
Ford and its suppliers, which were reinforced through
annual performance evaluations and bonuses for buyers
based on achieving year-over-year price reduction objectives. The foundation of the new ABF strategy was
a cultural shift from confrontational to collaborative
43
supplier relationships. Tony commented on his assessment of Ford’s current supply chain strategy: “We have
a problem with the business model in this industry. It is
not working effectively for our suppliers. It is not working effectively for us. When my day is dominated by
issues related to financially distressed suppliers, commodity price shocks, quality problems and costs issues,
it’s clear to me that there must be a better approach.”8
ABF targeted companywide cost reductions of
10 percent of Ford’s annual spend of production parts
by 2010—$7 billion per year—by adopting what Tony
considered best practices approach to supply chain
management and supplier partnerships: “It’s an environment between Ford and a select family of suppliers
where innovative ideas can emerge, and then be incubated, evaluated and incorporated into our products.”9
Under the new system, preferred suppliers would be
matched with Ford purchasing and engineering managers to work on projects to achieve quality, cost, and delivery goals. The 20 key elements of the ABF that Tony
planned to propose are provided in Exhibit 1, which
Brown described as “a kinder, gentler era of cooperation from global suppliers that can be implemented beyond North America.”10
EXHIBIT 1 Key Elements of ABF11
Ford Commitments
• Up-front reimbursement of supplier engineering, design, and
testing
• Long-term sourcing
• Improved commonality and
reuse
• Improved product, cycle plan,
and forecast volume stability
• Sharing of forecast volumes and
product plans (beyond 3 years)
• More disciplined program execution through Ford Global
Product Development system
Bilateral Commitments
•
•
•
•
•
•
•
•
Achieve best-in-class quality
Data transparency
Agree on detailed cost models
Focus on total costs, included
elimination of emphasis on bins
Competitive cost at Job no. 1,
with less emphasis on yearover-year price reductions
Open collaboration on global
manufacturing, engineering
footprint
Ongoing senior leadership
communication
Data exchange remains
confidential
Supplier Commitments
• Share current financial data
to demonstrate health
• Backstop other commodity
suppliers
• Manage and assure proper
working conditions in their
facilities and in the facilities of
sub-tiers
• Sourcing of minority- and
women-owned suppliers
• Use mutually agreeable multiparty agreement in directed
tier 2 sourcing scenarios
• Technological innovations will
be provided to Ford
7
www.ford.com/aboutford/microsites/sustainability-report-2006-07.
Stundza, “Ford Has a Better Idea, p. 49.
9
Ibid.
10
Ibid.
11
Presentation by Tony Brown, October 7, 2005, www.oesa.org/cmspages/getAttch.php?id=180.
8
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44 Purchasing and Supply Management
Tony was proposing that in the first phase of the ABF
implementation his supply organization would focus on
20 high-impact commodity groups, such as seats, tires,
and bumpers, where the automaker sent approximately
$35 billion per year with 200 suppliers. The plan was to
reduce the number of suppliers for these commodities to
100 by the 2009 model year. In the long term, Tony’s
objective was to shrink the production supply base from
2,500 to 1,000.12
FINALIZING THE PLAN
Tony recognized that there would be a great many questions from other Ford executives, members of his purchasing organization and suppliers regarding how ABF
would be implemented. There were obviously going to be
winners and losers from the existing Ford supplier community under ABF and many of Ford’s existing suppliers
would have to be told that they would not be participating
in future programs. The preferred suppliers would have
many questions regarding how their relationships would
function with Ford in the future. For example, it was expected that suppliers would benefit from higher capacity
utilization as a result of the increased production volumes. Furthermore, additional benefits were anticipated
from greater collaboration, early supplier involvement in
new product development, and supplier innovation. How
would the associated costs and benefits be measured and
shared among Ford and its suppliers?
Ford had a decades-long tradition of confrontational
relationships with its supplier community. A recent survey of North American automotive tier 1 suppliers ranked
Ford second to last with a score of 157 versus top-ranked
Toyota at 415 and Honda at 375 (scale: 500 ⫽ very good,
0 ⫽ very poor).13 Turning around relationships with suppliers could take years. Given the difficult times in the
industry and at Ford, Tony knew that Bill Ford would
have questions about supplier skepticism regarding the
company’s motivations behind ABF and how quickly the
plan would start to show results.
Tony Brown believed that it was necessary to make
major changes to Ford’s supply chain if the company was
going to survive. As he got ready for his meeting with
Mr. Ford, Tony pondered how he should proceed with
implementation, and specifically how suppliers could be
convinced to buy into the principles of ABF. Tony commented on the challenges that ABF presented: “This is not
business as usual. We’re not only asking our suppliers to
step up. We’re also asking ourselves to step up.”14
12
Jeffrey McCracken, “Ford Retools: Seeks Big Savings by Shaking Up Parts Supply System,” The Globe & Mail, September 29,
2005, p. B19.
13
John Henke, Planning Perspectives, Birmingham, Michigan, 2008.
14 “
Ford Key Suppliers Roll Out Innovative Business Model,” Ford Motor Company press release, http://media.ford.com
.newsroom/release, September 29, 2005.
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Chapter Three
Supply Organization
Chapter Outline
Objectives of Supply Management
Organizational Structures for Supply
Management
Small and Medium-Sized Organizations
Large Organizations
Centralized and Decentralized Supply
Structures
Hybrid Supply Structure
Specialization within the Supply
Function
Structure for Direct and Indirect
Spend
Managing Organizational Change in
Supply
Organizing the Supply Group
The Chief Purchasing Officer (CPO)
Reporting Relationship
Supply Activities and Responsibilities
What Is Acquired
Supply Chain Activities
Type of Involvement
Involvement in Corporate Activities
Influence of the Industry Sector on Supply
Activities
Supply Teams
Leading and Managing Teams
Cross-Functional Supply Teams
Other Types of Supply Teams
Consortia
Conclusion
Questions for Review and Discussion
References
Cases
3–1 Iowa Elevators
3–2 Roger Haskett
45
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46 Purchasing and Supply Management
Key Questions for the Supply Decision Maker
Should we
• Separate sourcing and commodity management responsibilities?
• Use cross-functional sourcing teams to make better supply decisions?
• Move towards greater centralization?
How can we
• Fit supply’s organizational structure better with the structure of the corporate
organizational structure?
• Gain the maximum benefits from our organizational structure?
• Structure and manage teams for effectiveness and efficiency?
Every organization in both the public and private sector is in varying degrees dependent on
materials and services supplied by other organizations. No organization is self-sufficient.
Even the smallest office needs space, heat, light, power, communication and office equipment, furniture, stationery, and miscellaneous supplies to carry on its activities. Purchasing
and supply management is, therefore, one of the key business processes in every organization. Almost every company has a separate supply function as part of its organizational
structure. One important management challenge is ensuring effective use of the resources
and capabilities of the supply organization and the supply chain or network to maximize
supply’s contribution to organizational objectives.
Managing the balance between the competitive environment, corporate strategy, and
organizational structure is an ongoing process for every company. Senior management
selects strategies designed to address competitive challenges and adopts an appropriate
corporate organizational structure to complement the company’s strategy. The structure of supply has to be congruent with this organizationwide structure. The challenge
for the chief purchasing officer (CPO) is to manage the supply organization to deliver
the maximum benefits within the predefined structure. For example, a chief executive
might decide that a decentralized organizational structure is appropriate in order to
allow flexibility in responding to customer requirements. The supply organization also
would be decentralized to the various business units to fit the corporate organizational
model.
The organizational structure of the supply function influences how supply executes
its responsibilities, how it works with other areas of the firm, and the skills and capabilities needed by supply personnel. Regardless of the structure adopted, work must
be assigned to ensure the efficient and effective delivery of goods and services to
the organization. This requires managing personnel and delegating responsibilities.
Managing the people in the supply organization to their full potential is a significant
challenge.
In this chapter, three questions are addressed: (1) What are the objectives of supply?
(2) How might supply be organized to achieve these objectives effectively and efficiently?
(3) What are the activities and responsibilities of supply management?
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Chapter 3
Supply Organization 47
OBJECTIVES OF SUPPLY MANAGEMENT
The standard statement of the objectives of the supply function is that it should obtain the
right materials (meeting quality requirements), in the right quantity, for delivery at the
right time and right place, from the right source (a supplier who is reliable and will meet
its commitments in a timely fashion), with the right service (both before and after the sale),
and at the right price in the short and long term. The supply decision maker might be likened to a juggler, attempting to keep several balls in the air at the same time, for he or she
must achieve these seven rights simultaneously.
It is not acceptable to buy at the lowest price if the goods delivered are unsatisfactory
from a quality/performance standpoint, or if they arrive two weeks behind schedule. On
the other hand, the right price may be higher than normal if the item in question is an emergency requirement where adherence to normal lead time would result in a higher total cost
of ownership. The right price is one aspect of lowest total cost of ownership. The supply
decision maker attempts to balance the often conflicting objectives and makes trade-offs
to obtain the optimum mix of these seven rights. Obtaining this balance with an eye to
both the short term and the long term requires supply managers to have both a tactical and
strategic perspective.
A more encompassing statement of the overall goals of supply would include the following nine goals:
1. Improve the organization’s competitive position. As a strategic player, the activities
of supply management must be focused on contributing to overall organizational strategy,
goals, and objectives. Supply managers must identify and exploit opportunities in the supply chain to contribute to revenue enhancement, asset management, and cost reduction.
Supply can secure the lowest total cost source of supply, provide access to new technologies, and design flexible delivery arrangements, fast response times, access to high-quality
products or services, and product design and engineering assistance.
Companies that are successful in the long run must constantly look for opportunities in the supply chain to provide a superior value proposition for their customers, and
supply represents a key area for such opportunities. Strategic supply is concerned with the
long-term survival and prosperity of the organization. It focuses on bottom-line impact,
the income statement, and the balance sheet. Chapter 2 discusses the potential contributions of purchasing and supply management to the overall strategy of the organization
and specific internal supply strategies for strengthening the organization’s competitive
position.
2. Provide an uninterrupted flow of materials, supplies, and services required to operate the organization. Stockouts or late deliveries of materials, components, and services
can be extremely costly in terms of lost production, lower revenues and profits, and diminished customer goodwill. For example (1) an automobile producer cannot complete the car
without the purchased tires, (2) an airline cannot keep its planes flying on schedule without
purchased fuel, (3) a hospital cannot perform surgery without purchased surgical tools, and
(4) an office cannot be used without purchased maintenance services.
3. Keep inventory investment and loss at a minimum. One way to ensure an uninterrupted material flow is to hold large inventories. But inventory assets require use of
capital that cannot be invested elsewhere, and the cost of carrying inventory may be
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48 Purchasing and Supply Management
20 to 50 percent of its value per year. For example, if supply can support operations with
an inventory investment of $10 million instead of $20 million, at an annual inventory
carrying cost of 30 percent, the $10 million reduction in inventory represents a savings of
$3 million in addition to freeing $10 million in working capital.
4. Maintain and improve quality. A certain quality level is required for each material or
service input; otherwise the end product or service will not meet expectations or will result
in higher-than-acceptable costs. The cost to correct a substandard quality input could be
huge. For example, a spring assembled into the braking system of a diesel locomotive can
cost less than $5.00. However, if the spring turns out to be defective when the locomotive
is in service, the replacement cost is in the thousands of dollars, caused by the teardown
required to replace the spring, the lost revenue to the railroad because the locomotive is
not in service, and the possible loss of locomotive reorders. Continuous improvement in
supplier quality is directly linked to an organization’s ability to compete effectively on a
worldwide basis.
5. Find or develop best-in-class suppliers. The success of supply depends on its ability
to link supply base decisions to organization strategy and its skill in locating or developing suppliers, analyzing supplier capabilities, selecting the appropriate supplier, and then
working with that supplier to obtain continuous improvements. Only if the final selection
results in suppliers who are both responsive and responsible will the firm obtain the items
and services it needs.
6. Standardize, where possible, the items bought and the processes used to procure
them. Standardization refers to the process of agreeing on a common specification or
process. Specifications and processes may be standardized across an organization,
an industry, a nation, or the world. Supply should constantly strive to standardize its
capital equipment, materials, MRO, and services purchases wherever and whenever
possible. For materials, standardization often leads to lower risk in the marketplace,
lower prices through volume purchase agreements, and lower inventory and tracking
costs while maintaining service levels. In the case of capital equipment, standardization results in reduction in MRO inventories and reduced costs for training staff on
equipment operation and maintenance. In the case of services, standardization leads to
supply base reduction, lower operating costs, more consistent service levels, and lower
prices. Supply management process standardization also can result in shortened cycle
time, lower transaction costs, and greater opportunities to share knowledge across
functional and organizational boundaries. Because standardization touches on multiple
stakeholders, it usually requires cross-functional and sometimes cross-organizational
teamwork.
7. Purchase required items and services at lowest total cost of ownership. Purchased
goods and services in the typical organization represent the largest share of that organization’s total costs. Consequently, the profit-leverage effect discussed in Chapter 1 can be
significant. Price is the most convenient method to compare competing proposals from
suppliers. However, supply’s responsibility is to obtain the needed goods and services at
the lowest total cost of ownership, which necessitates consideration of other factors—such
as quality levels, after-sales service, warranty costs, inventory and spare parts requirements, downtime, and so forth—that in the long term might have a greater cost impact on
the organization than the original purchase price.
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Chapter 3
Supply Organization 49
8. Achieve harmonious, productive internal relationships. Supply managers cannot
effectively accomplish their goals and objectives without effective cooperation with the
appropriate individuals in other functions. Therefore, it is useful to examine relationships
between supply and key internal business partners:
Supply and design engineering. Close to 70 percent of the value of any given
requirement is established during the first few phases of the standard acquisition
process: recognition and description of need. Therefore, close cooperation between
design engineering and supply to assure proper specifications is essential. The design
must be driven by final customer requirements for value and satisfaction, and be
designed for manufacturability and procurability. It is obvious that such close liaison
also needs proper involvement of marketing, operations, and finance/accounting to
recognize these opportunities and constraints. It is during the design phase that all of
these varied interests need to be appropriately incorporated, something that is unlikely
to happen unless the various functional experts can represent their points of view well
and are able to work effectively as a team. Too frequently, the failure to include supply
considerations properly at the design stages results in inadequate product or service
performance, costly delays, rework, and end user dissatisfaction.
Supply and operations. In most organizations, close supply–operations coordination is
essential to operational excellence. In manufacturing companies especially, the total
task of integrated logistics, meeting end-customer demands on the one side and using
the supply networks on the other, while managing material and information flow,
equipment, people, and space effectively, represents an incredible challenge. Meeting
quality, delivery, quantity, cost, flexibility, and continuity objectives profitably and
competitively requires strategic as well as tactical skills of both operations and supply
managers.
Supply and marketing/sales. Since supply and marketing are mirror images of each
other, with negotiation and customer service in common, there are benefits from
greater integration of the two functions. Although research indicates that supply is not
typically included in marketing planning, supply and marketing often serve on new
product development teams in organizations. Supply can offer information on current
and future market conditions and negotiation expertise; and marketing can keep supply
up to date on marketing campaigns, special promotions, and sales forecasts and
involve supply in meetings with end customers to help supply better understand
customer needs. In many organizations, there is an effort to use a strategic sourcing
process for spend categories such as advertising and media. This effort requires close
cooperation of supply and marketing.
Supply and accounting/finance. Supply and accounting/finance interact in the areas of
accounts payable, planning, and budgeting. Lack of horizontal goal alignment often
leads to behavior in one area that conflicts with behavior in the other area. For
example, finance/accounting may adopt a payment policy that is at odds with the
payment terms of the contract. From the finance perspective, holding onto cash as long
as possible is a good way to contribute to the organization’s financial goals. From the
supply perspective, building sound, mutually beneficial relationships with key
suppliers contributes to financial performance. Supply managers often argue that
accounting focuses too much on short-term gains from holding cash rather than the
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50 Purchasing and Supply Management
longer-term benefits of a strong buyer–supplier relationship that is influenced by
paying according to contractual payment terms. Improved communication between
supply and accounting/finance and greater goal congruence can help to alleviate some
of the problems. Supply can help finance by providing funds flow forecasts, focusing
on inventory minimization, and providing market information.
9. Accomplish supply objectives at the lowest possible operating costs. It takes
resources to operate supply: salaries, communications expense, supplies, travel costs,
computer costs, and accompanying overhead. The objectives of supply should be
achieved as efficiently and economically as possible. Process inefficiencies represent waste and lead to excessive operating costs and unnecessarily high total cost of
ownership. Supply managers should be continually alert to improvements possible in
purchasing and supply processes, methods, procedures, and techniques. For example,
opportunities to reduce transaction costs include e-procurement systems that automate the process from requisition to payment and purchasing cards and e-catalogs for
small-value purchases. Companies with efficient supply processes can create competitive advantage through reduced costs, improved flexibility, faster time to market, and
greater compliance, while allowing supply personnel to concentrate on value-added
activities.
The objectives of supply must ultimately contribute to the attainment of short- and longterm organizational strategy, goals, and objectives. The process and function can be organized in a number of different ways to maximize supply’s contribution effectively and
efficiently.
ORGANIZATIONAL STRUCTURES FOR SUPPLY MANAGEMENT
Ultimately the supply organization structure must be aligned with the corporate structure
and strategy. In addition, organizational size and the need for specialization with supply
also need to be taken into account.
Small and Medium-Sized Organizations
In practice it has been proven that assigning the supply function to supply professionals,
properly trained and charged with the appropriate responsibilities and authorities, contributes more efficiently and effectively to organizational goals and strategies than assigning
supply responsibilities to those for whom supply is a secondary responsibility. Nevertheless, in single business unit organizations, particularly small enterprises, it is not unusual to see supply responsibilities shared by a variety of individuals who have no supply
expertise and purchase their own requirements from local retailers or wholesalers. As the
size of the business unit increases, the idea of assigning a professional the responsibility of
supply emerges and a separate function is created.
The size and activities of the supply function in a single business unit organization
will depend on a number of factors, such as the size of the company and the nature of its
business. Figure 3–1 provides an example of a supply organization in a typical mediumsized, single business unit enterprise. Obviously in small companies where the supply staff
consists of only one or two individuals, the staff is expected to be flexible in terms of their
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Chapter 3
FIGURE 3–1
Example of a
Typical Supply
Organization
in a SingleLocation,
Medium-Sized
Company
Supply Organization 51
Director of
Supply
Commodity
Manager
Commodity
Manager
Manager
Administration
and Processes
Buyer
Buyer
Manager
e-Purchasing
Buyer
Buyer
Manager
p-cards
Manager
Purchasing
Research
Materials
Manager
Stores/
Warehouse
Manager
Receiving
Inspection
Manager
Manager
Transportation
capabilities and skills. Specialization will occur as the organization gets larger and the
company can afford to hire additional supply personnel.
Large Organizations
In large companies the centralization–decentralization issue is of key importance for the
supply structure. The overall corporate structure sets the framework for the supply structure. Structural options can be viewed as a continuum ranging from centralized at one
extreme to decentralized at the other. Centralization refers to where spending decisions
are made, not where the purchasing and supply staff are located geographically. Therefore,
the degree of centralization is reflected by the amount of spend managed or controlled by
corporate supply. Three common organizational models are:
1. Centralized, where the authority and responsibility for most supply-related functions
are assigned to a central organization.
2. Hybrid, where authority and responsibility are shared between a central supply organization and business units, divisions, or operating plants. Hybrid structures may lean
more heavily toward centralized or decentralized depending on how decision-making
authority is divided. One type of hybrid supply structure is a “center-led” organization
in which strategic direction is centralized and execution is decentralized.
3. Decentralized, where the authority and responsibility for supply-related functions are
dispersed throughout the organization.
CAPS Research conducts Purchasing Performance Benchmarking Studies for a wide
range of industries. One of the benchmarks is whether the participating companies use a
centralized, decentralized, or hybrid structure. To read about the type of structure common
in different industries, visit the CAPS Web site at http://www.capsresearch.org.
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52 Purchasing and Supply Management
Centralized and Decentralized Supply Structures
There are advantages and disadvantages to centralization and to decentralization. Table 3–1
summarizes the advantages and disadvantages of a centralized supply structure and
Table 3–2 summarizes the advantages and disadvantages of a decentralized supply structure.1
Hybrid Supply Structure
In an organization with multiple business units, different divisions or business units often
sell different products or services requiring a different mix of purchased items. Often the
division or business unit is operated as a profit center where the division manager is given
total responsibility for running the division, acts as president of an independent firm, and is
judged by profits made by the division. Since purchases are the largest single controllable
cost of running the division and have a direct effect on its efficiency and competitive position, the profit-center manager may insist on having direct authority over supply. This has
led firms to adopt decentralized–centralized supply, or a hybrid organizational structure,
in which the supply function is partially centralized at the corporate or head office and
partially decentralized to the business units.
Often the corporate supply organization works with the business unit supply departments
in those tasks that are more effectively handled on a corporate basis: (1) establishment
TABLE 3–1
Advantages
Potential
Advantages
and
Disadvantages
of
Centralization
• Strategic focus
• Greater buying specialization
• Ability to pay for talent
• Consolidation of requirements—clout
• Coordination and control of policies
and procedures
• Effective planning and research
• Common suppliers
• Proximity to major organizational
decision makers
• Critical mass
• Firm brand recognition and stature
• Reporting line—power
• Cost of purchasing low
Disadvantages
•
•
•
•
•
•
•
•
•
•
Lack of business unit focus
Narrow specialization and job boredom
Cost of central unit highly visible
Corporate staff appears excessive
Tendency to minimize legitimate
differences in requirements
Lack of recognition of unique business
unit needs
Focus on corporate requirements, not on
business unit strategic requirements
Most knowledge sharing one-way
Even common suppliers behave differently
in geographic and market segments
Distance from users
• Tendency to create organizational silos
• Customer segments require adaptability
to unique situations
• Top management not able to spend time
on suppliers
• High visibility of purchasing operating costs
1
M. R. Leenders and P. F. Johnson, Major Structural Changes in Supply Organizations ( Tempe, AZ: CAPS
Research, 2000).
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Chapter 3
TABLE 3–2
Potential
Advantages
and
Disadvantages
of
Decentralization
Advantages
• Easier coordination/communication
with operating department
• Speed of response
• Effective use of local sources
• Business unit autonomy
• Reporting line simplicity
• Undivided authority and responsibility
• Suits purchasing personnel preference
• Broad job definition
• Geographical, cultural, political,
environmental, social, language,
currency appropriateness
• Hide the cost of supply
Supply Organization 53
Disadvantages
• More difficult to communicate among
business units
• Encourages users not to plan ahead
• Operational versus strategic focus
• Too much focus on local sources—ignores
better supply opportunities
• No critical mass in organization for
visibility/effectiveness—“whole person
syndrome”
• Lacks clout
• Suboptimization
• Business unit preferences not congruent
with corporate preferences
• Small differences get magnified
• Reporting at low level in organization
• Limits functional advancement
opportunities
• Ignores larger organization considerations
• Limited expertise for requirements
• Lack of standardization
• Cost of supply relatively high
of policies, procedures, controls, and systems; (2) recruiting and training of personnel;
(3) coordination of the purchase of common-use items in which more “clout” is needed,
(4) auditing of supply performance, and (5) development of corporatewide supply strategies. Therefore, hybrid organizational structures attempt to capture the benefits of both
centralized and decentralized structures by creating an organizational structure that is neither completely centralized nor decentralized. (See Figure 3–2.)
Structure affects processes, procedures, systems, and relationships. Whether supply
is centralized, decentralized, or a hybrid, supply personnel must focus on maximizing
the advantages of the structure and minimizing the disadvantages. Supply managers can
develop and implement strategies to overcome the obstacles and fully exploit the opportunities of organizational and supply structure.
Specialization within the Supply Function
If the supply organization is to contribute well to organizational goals and objectives, it
needs to be staffed by professionals with clearly defined responsibilities. Specialization
within the supply department allows staff to develop expertise in particular areas and may
require the creation of specialized groups within the supply organizational structure. Most
large supply organizations consist of four general areas of specialization: sourcing and
commodity management, materials management, administration, and supply research.
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54 Purchasing and Supply Management
FIGURE 3–2
Potential
Advantages
of the Hybrid
Structure
Centralized
Disadvantages
Decentralized
Advantages
Advantages
Disadvantages
Hybrid
Sourcing and Commodity Management
These personnel develop commodity strategies, identify potential suppliers, analyze supplier capabilities, select suppliers, and determine prices, terms, and conditions of supplier
agreements; they create contracts and purchase orders. This activity is normally further
specialized by type of commodity to be purchased, such as raw materials (which may be
further specialized); fuels; capital equipment; office equipment and supplies; and maintenance, repair, and operating (MRO) supplies. Figure 3–3 presents a job description for a
commodity specialist at Deere & Company.
A variation of commodity management is project buying, in which the specialization of
buying and negotiation is based on specific end products or projects, requiring the buyer to
be intimately familiar with all aspects of the project from beginning to end. Project buying
might be used in the supply organization of a large general contractor, where the purchasing for each job is part of a self-contained, temporary organization. At the completion
of the project, the buyer then would be reassigned to another project. The United States
Defense Acquisition University trains special project managers who are responsible for the
proper acquisition and development of new military equipment initiatives. Such projects
may last as long as 20 years.
Materials Management
This group manages the contract after it is signed, directs the flow of materials and services
from the supplier, and keeps track of the supplier’s delivery and quality commitments
to avoid any disruptive surprises. If problems develop, the materials management group
pressures and assists the supplier to resolve them. Materials management activities are frequently handled at the local plant or office level and involve regular communication with
suppliers concerning requirements, such as order quantities and delivery dates. Figure 3–4
presents a job description for a supply management planner.
Administration
This group handles the physical preparation and routing of the formal purchase documents,
manages the department budget, keeps the necessary data required to operate the department, and prepares reports needed by top management and supply. These personnel will
likely manage operation of information systems, including e-procurement systems, B2B
e-commerce, and EDI.
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Chapter 3
Supply Organization 55
FIGURE 3–3
Commodity
Specialist Job
Description
for Deere &
Company
Job Title:
Department:
Job Function:
Commodity Specialist
Supply Management
Locate sources for and procure materials, products, supplies or services
to support the assigned commodity requirements of the enterprise.
Manage the relationships with suppliers.
Primary Duties:
1. Manage source selection and development through a team process including the
evaluation of cost, quality, and manufacturing systems.
2. Develop and manage internal and external supplier/customer relationships, including
strategic alliances where appropriate.
3. Lead and/or participate on simultaneous engineering teams; facilitate the integration
of suppliers into the product delivery process (PDP).
4. Evaluate the cost effectiveness of designs, procure tooling, and qualify processes to
assure the product meets specifications.
5. Make recommendations for design change and/or influence design through personal
or supplier involvement.
6. Develop and execute supply management strategies to manage cost, quality, and
continuous improvement.
7. Develop material control and logistics objectives.
8. Act as a primary communications link between tactical and strategic purchasing
functions and business units; participate in team activities.
Supply Research
Supply researchers work on special projects relating to the collection, classification, and
analysis of data needed to make better purchasing decisions. Activities include studies on
use of alternate materials, long-range demand, price and supply forecasts, and analysis of
what it should cost an efficient supplier to produce and deliver a product or service.
This group is also responsible for performing benchmarking studies. For example, the
global purchasing processes and systems group at Cable and Wireless plc, in the United
Kingdom, benchmarks its purchasing processes to identify opportunities to improve its
supply systems.2
2
M. R. Leenders and P. F. Johnson, Major Changes in Supply Chain Responsibilities ( Tempe, AZ: CAPS
Research, 2002).
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56 Purchasing and Supply Management
FIGURE 3–4
Supply
Management
Planner Job
Description
for Deere &
Company
Job Title:
Department:
Job Function:
Supply Management Planner
Supply Management
To expedite, schedule, and/or analyze requirements for purchased
materials in accordance with established requirements and inventory
control criteria. May interact with suppliers to establish procedural
agreements, obtain delivery commitments, and resolve quality problems.
Primary Duties:
1. Manages specific supplier performance and feedback along with managing day-to-day
business plan and relationships with supplier.
2. Plans and/or executes inventory goals by product/supplier and plans/develops delivery
system to meet material control objectives (i.e., JIT delivery, P.O.U.D., EDI).
3. Schedules material based on requirements and expedites deliveries that are delinquent
or expected to be delinquent. Tracks and resolves problems with inbound shipments.
4. Interprets systems output to determine items requiring follow-up to suppliers on
materials ordered to assure on-time delivery.
5. Is involved with the day-to-day problem resolution/corrective action with suppliers: to
scrap, return, reclaim, or replace rejected material. Is responsible for bringing products
within specifications.
6. Acts as the primary communications link between tactical and strategic purchasing
functions and business unit; participates in supply management team activities.
7. Costs and implements current part revisions, including tooling, as part of the decision
processing activity. Also reads and reacts to engineering decisions.
8. Conducts price/economic order quantity analysis and compares multiple quotes,
including piece price, freight, duty, performance systems, and supplier rating. Also
investigates invoice price errors.
Structure for Direct and Indirect Spend
Direct spend includes any goods that go into the end product; indirect spend is comprised
of the goods and services that are needed to run the organization. Indirect spend includes
purchases such as professional services, utilities, travel, employee benefits, and office supplies. In many organizations, the locus of control over direct spend is in a highly centralized supply group. This makes sense because anything that ultimately touches the final
customer is worthy of expertise.
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Indirect spend, on the other hand, is often outside the loop of a structured sourcing process and supply authority and responsibility is often left in the hands of the internal user. For
example, a marketing manager needing to hire temporary labor would conduct the purchasing process in his or her own way. This highly decentralized approach leads to a fragmented
spend for temporary labor, including multiple suppliers, multiple rates, and varying contract
terms and conditions. This is partly due to the belief that these types of purchases require a
level of knowledge and expertise not found in a typical supply department.
The increasing focus on strategic cost management has led many senior managers to
turn their attention to indirect spend to realize cost savings, reductions, or avoidances.
To better manage indirect spend, some organizations will pull indirect spend categories
into the purchasing process. Others expect supply managers to convince internal users
that there is value in following a structured sourcing process. In some cases, supply provides analysis and recommendations, but the budget owner makes the purchasing decision.
Cross-functional teams consisting of internal users (often across business units) and buyers
or commodity managers may be given responsibility for the category. Sourcing, evaluating, and selecting suppliers for indirect spend will be discussed in greater detail in Chapter 12. Any purchase dollars that are not managed through a structured sourcing process
may represent a target for cost savings, reduction, or avoidance.
Managing Organizational Change in Supply
Firms frequently make major changes to their supply organizational structure. CAPS
conducted a study in 2000, in part to answer two questions: (1) Why are there so many
structural changes in supply organizations at large companies? (2) If the hybrid organizational structure is theoretically so attractive, then why do so many large firms not use
this structure and/or move out of it?3 First, the researchers found that organizational structure change was the result of a change in the overall corporate organizational structure. In
none of the situations did the CPO have free choice to select the supply organizational
structure that he or she deemed appropriate for the circumstances. Rather, the supply organizational structure was forced to be congruent with the overall corporate structure. The
challenge for supply executives, therefore, was to maximize the benefits of the organizational structure while minimizing the disadvantages.
Secondly, there are a number of implementation issues to consider when making a
major organizational structure change in supply. Major changes affect the lives of many
people and create an atmosphere of apprehension among the staff. Implementing change
places significant pressures on the CPO, who not only has to worry about managing the
day-to-day affairs of the supply department, but also has to successfully implement the
organizational change. The challenges associated with these issues frequently contribute to
the need to seek assistance from consultants when implementing a major structural change.
Changes toward Centralization
When moving toward centralization, two concerns were sources of supply talent and information technology. During the transition, the source of supply talent at all levels of the
supply function was a significant challenge. Experienced senior corporate-level supply
3
Leenders and Johnson, Major Structural Changes in Supply Organizations ( Tempe, AZ: CAPS Research,
May 2000).
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58 Purchasing and Supply Management
personnel may not exist in-house. How and where to develop such organizational talent
represented an important implementation issue. Some firms placed a greater priority on
CPO credibility within the organization, as opposed to previous supply experience. Others
identified new CPOs with previous supply experience to handle the change process. At the
middle and junior levels, additional staff with specialized skills in areas such as contracting
was required. Quite often, the existing supply talent in the decentralized organization
was perceived to lack the required training or experience needed in the new centralized
environment.
Changes toward Decentralization
The CAPS research identified one implementation issue unique to the sites in the study
moving toward decentralization: how to dismantle the centralized supply unit effectively.
For example, Ontario Hydro created a shared services function that was responsible for negotiating corporatewide agreements and establishing and maintaining corporate purchasing policies, while the business units were responsible for materials management activities.
The approach taken by Hoechst was to create a separate legal entity, Hoechst Procurement
International, which would also offer purchasing services to other companies on a feefor-service basis. The key objective in both situations was to preserve at least some of
the organization’s core supply capabilities and talent, while adapting to the new structural
requirements of the company.
ORGANIZING THE SUPPLY GROUP
Once the corporate organizational structure is set, no matter what organizational design
is chosen, delegation takes place within it. Whether the organization structure is based on
functions, products, or business processes is immaterial; what really matters is that work
must be assigned and executed in accordance with strategic plans and organizational goals.
It follows logically that organizational planning and delegation are important segments of
the integration of strategic goals and organizational designs.
The following sections describe the key aspects of supply organizational design, including the role of the chief purchasing officer, supply’s status in the organization, and its
reporting relationship and internal relationships. Even though the focus is on large supply
organizations, many of the comments are also relevant for smaller supply organizations.
The Chief Purchasing Officer (CPO)
The chief purchasing officer (CPO) or chief supply officer (CSO) is defined as the “most
senior” or “top level” executive in a “firm’s corporate (executive level) office or major
division, such as a strategic business unit (SBU), who has formal authority and responsibility to manage his or her firm’s (or SBU’s) purchasing, buying or sourcing functions
for the procurement of goods and services from external suppliers.”4 The CPO’s responsibilities may be divided and apportioned among managers and departments, but the functional responsibility and authority of the CPO should be definitely recognized. Moreover,
4
T. E. Hendrick, and J. A. Ogden, Chief Purchasing Officers’ Compensation Benchmarks and Demographics:
A 2001 Study of Fortune 500 Firms ( Tempe, Arizona: CAPS Research, 2002).
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functionalization implies that all the responsibilities reasonably involved in the supply
function must be given to the CPO, covering the relevant supply network links as well as
the full range of organizational needs. The essential principle is that there are certain universally recognized duties pertinent to this function and that these duties should be placed
in a separate group equal in status with the other major functions of the organization.
The changes in supply management have affected everything from what the function
is called to the titles of the people performing the tasks to the tasks that are performed.
There is no common title for the individual who holds the top supply position in a large
organization in North America. Depending on the role of supply in the organization, the
reporting line, and where it is placed on the organization chart, the title may be chief purchasing officer, vice president, director, or manager. Attached to that may be purchasing,
procurement, supply management, sourcing, strategic sourcing, logistics, or supply chain
management. It is quite common to see CPO titles such as vice president, strategic sourcing and supply; vice president, purchasing; vice president, supply chain management; or
director, global procurement. The titles in the cases used in this text provide a good range
of titles in current use.
Profile of the CPO
The following profile of the average CPO emerged from the CAPS study.5 The average
CPO is a well-educated 49-year-old who has been at his or her organization for 14 years
and CPO for a little over four years. While most CPOs have previous experience in supply,
three-quarters of the CPOs in the study had worked in at least one other function. Approximately 60 percent of CPOs had the title of vice president and the title most likely included
the word purchasing, procurement, or supply in it, such as vice president, global procurement or vice president of supply chain management.
Typically there are one to two levels between the CPO and the CEO. The CPO was
found to report to the CEO in 14 percent of the companies in the CAPS study. The most
common reporting lines were to senior vice president/group vice president, vice president
of finance/CFO, and executive vice president. The CPO may have overall management
responsibility for nontraditional purchases such as corporate travel, food services, real estate, and printing. Additionally, the CPO might have responsibility for logistics (which
includes inbound and outbound transportation, fleet management, warehousing, materials
handling, order fulfillment, inventory management, supply/demand planning, and management of third-party logistics providers), quality, accounts payable, document/contract
management, leadership of the supply process, materials, manufacturing, distribution, and
facility management.
CPO Trends
Several trends have emerged over at least the last 10 years:6
• Education levels are increasing. Almost all CPOs hold a bachelor’s degree; about half,
a graduate degree, typically an MBA.
5
P. F. Johnson, and M. R. Leenders, Supply’s Organizational Roles and Responsibilities ( Tempe, AZ: CAPS
Research, 2004).
6
P. F. Johnson, and M. R. Leenders, Supply Leadership Changes ( Tempe, AZ: CAPS Research, 2007).
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60 Purchasing and Supply Management
• Reporting lines are changing. CPOs tend to report higher in the organization than they
did in the 1980s and 1990s.
• CPOs are increasingly being hired from outside the organization rather than promoted
from within. The 2004 CAPS study found that CPO tenure with their organization had
declined to 14 years, from 18 years in 1995, and that approximately one-third of CPOs
were hired into the position from another firm.
• CPOs are increasingly being hired from functional areas other than supply.
• When a new CPO replaces a current CPO, the current CPO is promoted or leaves the
company for a similar position in another firm.
• CPO reporting lines change every 2.5 years on average, which means that the typical
CPO will have at least two different bosses during his or her tenure in the role.
• The CPO role is still new in many organizations.
Reporting Relationship
The executive to whom the CPO reports gives a good indication of the status of supply and
the degree to which it is emphasized within the organization. If the chief purchasing officer
has vice presidential status and reports to the CEO, this indicates that supply has been recognized as a top management function. The lower that supply reports in the organization,
the less influence supply is likely to have on corporate strategy.
When supply is not given the same status as other functions, it must be placed under
another senior functional executive. In many cases, supply reports to the chief financial
officer because of the immediate impact of supply decisions on cash flows, the size of the
annual spend, and the amount of money tied up in inventory. Organizational focus on strategic cost management also supports the decision to place supply under finance. In organizations where a high percentage of annual spend is for production requirements, supply
often reports to the top manufacturing executive. In a shared services model, supply along
with legal, accounting, human resources, and other functions might report to an administrative vice president. In a heavily engineering-oriented firm, the reporting relationship might
be to the chief of engineering to get closer communication and coordination on product
specification and quality control.
Factors that influence the level at which the supply function is placed in the organizational structure cover a broad spectrum. Among the major ones are:
1. The amount of purchased material and outside services costs as a percentage of either
total costs or total income of the organization. A high ratio emphasizes the importance
of effective performance of the supply function.
2. The nature of the products or services acquired. The acquisition of complex components or extensive use of subcontracting represents a difficult supply problem.
3. The extent to which supply and suppliers can provide competitive advantage.
The important consideration in determining to whom supply should report relates to
where it will be most effective in realizing its contribution to the organization’s objectives.
Supply should report at a level high enough in the organization so that the key supply aspects of strategic managerial decisions will receive proper consideration.
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SUPPLY ACTIVITIES AND RESPONSIBILITIES
Supply management can be described as a series of activities that must be managed
effectively for the organization to deliver best value to the final customer. According to a
CAPS Research report, Major Changes in Supply Chain Responsibilities,7 roles and responsibilities of supply fall into four general categories: (1) what is acquired, (2) supply chain
activities, (3) type of involvement in categories 1 and 2, and (4) involvement in corporate
activities.
What Is Acquired
The items acquired by the supply group vary from organization to organization and items
are added or deleted depending on circumstances in the buying organization. The acquisition segments include raw materials, standard and special direct purchases, MRO, capital,
services, and resale. Nontraditional purchases are spend categories that have typically been
managed outside of the purchasing and supply management process. In some organizations, purchasing activities are limited to production-related materials and services, leaving
responsibility for nonproduction or indirect materials and services in the hands of users.
The amount of annual spend that falls outside the management or control of supply
ranges from a low of about 2 percent to a high of about 40 percent. This often includes large
amounts for capital equipment, utilities, insurance, computers and software, travel, real estate, and construction services. Senior management in many organizations has recognized
the significant opportunities from applying the skills of their supply group and the benefits
of a structured sourcing process in the acquisition of nontraditional materials and services.
The Iowa Elevators case demonstrates the opportunities for supply to capture cost reductions in a large service organization. Exhibit 2 in the case provides a list of spend
categories that include direct (e.g., farm supplies) and indirect (e.g., travel) purchases.
In contrast to Iowa Elevators, the Roger Haskett case describes capital equipment
purchasing. How to finance and manage capital expenditure purchases is also covered in
Chapter 6.
Supply Chain Activities
Supply has assumed greater responsibilities in a wide range of areas, including those not
seen as traditional, as companies strive to leverage profit opportunities and create competitive advantage through their supply practices. Today’s supply management organization
has more responsibilities than the traditional “buying” activities once associated with the
function. The activities handled by the supply function vary from firm to firm, even within
the same industry. However, regardless of company size, there are a number of activities
common to most supply organizations (see Table 3–3).
The addition or deletion of activities in any organization can be categorized as internally
or externally focused. Internally focused activities include accounts payable, centralized coordination of purchasing, cost management, legal, materials management and logistics, production planning, quality, and supply budget and financial management. Externally focused
7
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Leenders and Johnson, Major Changes in Supply Chain Responsibilities ( Tempe, AZ: CAPS Research, 2002).
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62 Purchasing and Supply Management
TABLE 3–3
Supply
Activities
Area of Responsibility
Purchasing/buying
Purchasing research
Inventory control
Transportation
Environmental and
investment recovery/disposal
Forecasting and planning
Outsourcing and
subcontracting
Nonproduction/nontraditional
purchases
Supply chain management
Activities
• Creating contracts and supply agreements for
materials, services, and capital items
• Managing key purchasing processes related to
supplier selection, supplier evaluation, negotiation,
and contract management
• Identifying better techniques and approaches to
supply management, including benchmarking
processes and systems
• Identifying medium- and long-term changes in
markets and developing appropriate commodity
strategies to meet future needs
• Identifying supply chain trends and opportunities
for better materials and services
• Managing inventories and expediting material delivery
• Establishing and monitoring vendor-managed
inventory systems
• Managing inbound and outbound transportation
services, including carrier selection
• Managing supply chain–related activities to assure
compliance with legal and regulatory requirements
and with company environmental policies
• Managing disposal of surplus materials and
equipment
• Planning production and forecasting short-,
medium-, and long-term requirements
• Evaluating potential suppliers and negotiating
contracts
• Supporting the transition from internal production
to external supply and vice versa
• Managing cost-effective delivery of nonproduction
and nontraditional purchases, such as office
supplies, security services, janitorial services,
advertising, and insurance
• Implementing and managing key supplier
relationships and supplier partnerships, including
supplier development and participation on crossfunctional and cross-organizational teams
• Developing strategies that use the supply network
to provide value to end customers and contribute to
organizational goals
activities may have either a supplier focus or a customer focus. Supplier-focused activities
include inbound logistics, supplier development, raw material procurement for suppliers,
supplier evaluation and communication, e-procurement, and outsourcing or subcontracting.
Customer-focused activities include outbound logistics, involvement with new business
development and new product development, and programs and customer bid support.
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Type of Involvement
Supply can have no involvement or documentary, professional, or meaningful involvement in what is acquired and in supply chain activities. No involvement means supply is
excluded completely. Documentary involvement requires the supply function to act as a
recorder, a sender of purchase orders, or a receiver of bids, but important supply decisions
are made outside supply. Professional involvement implies that supply professionals have
the opportunity to exercise their expertise in important acquisition process stages. Meaningful involvement means that parties outside the supply group are willing and able to take
supply considerations into account in managing their own areas of responsibility. They
routinely and actively request input and assistance from supply personnel and, in turn, also
are involved in supply decisions traditionally considered the prerogative of supply. One
measure of meaningful involvement is the extent to which supply is expected to take part
in major corporate activities.
Involvement in Corporate Activities
Major strategic corporate initiatives include mergers and acquisitions, new facility planning, new product development, outsourcing, revenue enhancement, technology planning,
corporate e-commerce initiative, and corporate cost reduction initiative.
Influence of the Industry Sector on Supply Activities
The industry sector influences supply responsibilities. Firms that manufacture discrete
goods such as cars, consumer electronics, apparel, and furniture face a significant number
of dynamic, product-related pressures that affect the supply function and that are less likely
to occur in commodity-oriented process industries. These pressures include changing consumer preferences, product innovation, and relatively short product life cycles.
Purchased materials and services also represent a high percentage of the cost of sales
for firms in discrete goods industries. For example, purchased materials and services can
represent 80 percent of the average cost of an automobile. Consequently, firms in discrete
goods industries are likely to have supply departments that play a key role in each step in
the materials cycle, from product design to production.
The role of supply in process industry firms, such as oil and gas, chemicals, glass,
and steel industries, is typically different compared to firms in discrete goods industries.
Many process industry firms have two supply organizations: a specialized supply group,
such as a commodity trading department, that frequently handles purchasing for important raw materials and a purchasing group responsible for the acquisition of materials,
supplies, and services that support the operation of facilities. For example, it is common
practice for crude oil acquisition in most large integrated oil companies to be handled by
a commodity trading group, while other purchases are handled by the supply organization. As a result, although the cost of purchased materials and services might represent a
substantial portion of the total cost of sales, the supply function for firms within processing industries is frequently excluded from the acquisition of the single most important
raw material.
In the public not-for-profit sector and service sectors, most purchases are for end use
within the organization itself, with the exception of purchases for resale, such as in distribution and retail. In fast-growing organizations, capital purchases may represent a large
percentage of total acquisition expenditures.
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64 Purchasing and Supply Management
SUPPLY TEAMS
Corporate organization structures are leaner, flatter, more adaptive, and more flexible than
in the past. Rigid functional structures have been replaced by a greater dependence on
cross-functional teams that overlay the functional organization to push decisions lower in
the organizational hierarchy. Teams bring together a number of people, often from different functional areas, to work on a common task. It is believed that teams provide superior
results compared to individual efforts as a result of the range of skills, knowledge, and
capabilities of team members. They also promote cross-functional cooperation and communication and may facilitate consensus building in the organization.
Teams are used by a number of functions for a variety of purposes, such as improvements in quality, cost, or delivery; product development; process engineering; and technology management. They can be project oriented or ongoing. Project teams are brought
together for a limited time to achieve a specific goal or outcome, such as completion of a
capital project or an e-commerce initiative. Ongoing teams continue indefinitely, such as
a commodity-sourcing team that manages the process and the supplier relationship.
Leading and Managing Teams
Many teams fail to meet performance expectations. Changing to a team-based workplace
requires a significant level of commitment and training of management and individual
team members. Critical success factors include:
•
•
•
•
•
•
•
•
Supportive organizational culture, structure, and systems.
A common compelling purpose, measurable goals, and feedback for individual and team.
Organized for customer satisfaction rather than individual functional success.
All functional areas involved in up-front planning, shared leadership roles, and role
flexibility.
The right people (right qualifications), in the right place (on a team that needed their
skills), at the right time (when those skills were needed).
A common, agreed-upon work approach and investment in a high level of communication.
Dedication to performance and implementation with decisions delegated to the appropriate level.
Integration of all relevant functional areas and various teams throughout the project life
cycle.
Senior management often tries to combine the flexibility of decentralized supply management and the buying power and information sharing of centralized supply through the
use of teams. Various types of purchasing and supply management teams may be used,
including cross-functional teams, teams with suppliers, teams with customers, teams with
both suppliers and customers, supplier councils (key suppliers), purchasing councils (purchasing personnel only), commodity management teams (purchasing personnel only), and
consortia (pool buying with other firms).
Cross-Functional Supply Teams
Cross-functional teams consist of personnel from multiple functions focused on a supplyrelated task. It is generally believed that high-performing, cross-functional teams will get
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better results on the task, with greater benefit to the organization as a whole, at lower
costs, in less time, with greater stakeholder buy-in. Effective cross-functional teams save
time by allowing a simultaneous, rather than a sequential, approach. For example, if key
stakeholder groups are involved in the development of a new process from concept through
design, development, and rollout, the process may be better to start with, more widely accepted, and adopted quickly. The cycle time may be less than the nonteam approach but
more of the work is concentrated at the beginning of the process.
Three important cross-functional supply teams are sourcing, new product development,
and commodity management.
Sourcing Teams
A cross-functional sourcing team includes supply and representatives from other relevant
functional areas. The team can focus on a wide range of projects including developing
cost-reduction strategies; developing local, business unit, or organizationwide sourcing
strategies; evaluating and selecting suppliers; performing value analysis; analyzing spend;
and identifying consolidation opportunities.
For example, to foster internal strategic business alignment, the CPO at General Mills
created a position called director of sourcing operations (DSO). The prime focus of the
DSO was to work with cross-functional business unit teams comprised of marketing,
R&D, manufacturing, distribution, and accounting on important strategic initiatives. The
DSO brought a sourcing perspective and provided a leadership role and alignment between
sourcing strategies and business unit strategies. Specific initiatives were proposed as part
of the annual business plan and DSO performance was evaluated considering team results.8
New Product/Service Development Teams
Effective new product or service development processes can improve an organization’s
competitive position. Cross-functional teams can shorten development cycle times, improve quality, and reduce development costs by operating concurrently rather than sequentially. Rather than each functional area performing its task and passing the project off to the
next functional area, the key functional groups—usually design, engineering, manufacturing, quality assurance, purchasing, and marketing—work on the new product development
simultaneously. Because a large percentage of a product’s cost is purchased materials,
early supplier involvement is often needed. When surveyed, many supply managers report
greater involvement in new product/service design and development.
Commodity Management Teams
Commodity management teams are formed when expenditures are high and the commodity is complex and important to success. These are generally permanent teams that provide
increased expertise, more cross-functional coordination and communication, better control
over standardization programs, and increased communication with suppliers. They develop
and implement commodity strategies aimed at achieving the lowest total cost of ownership.
They engage in a number of activities, including supply base reduction, consolidation of
requirements, supplier quality certification, management of deliveries and lead times, cost
savings projects, and management of supplier relationships.
8
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Johnson and Leenders, Supply Leadership Changes ( Tempe, AZ: CAPS Research, 2007, p. 59).
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66 Purchasing and Supply Management
The Delphi Corporation case in Chapter 15 describes how the company used approximately 30 commodity teams, across four categories—chemical, electrical, metallic, and
technological—to manage its approximately 80 percent of its spend.
Other Types of Supply Teams
In addition to the three common forms of cross-functional teams, there are at least six
additional approaches to supply teams: supplier participation, customer participation, colocation of supply, co-location of suppliers, supplier councils, and supply councils.
Teams with Supplier Participation
Supplier participation in cross-functional sourcing teams depends on the nature of the assignment. For example, it makes sense to include suppliers in teams assigned to develop
supplier capabilities or improve supplier responsiveness, but not on teams assigned to
evaluate and select new suppliers.
Involving suppliers at the product design stage can produce substantial benefits and is
common in discrete goods manufacturing industries, such as automotive and consumer
electronics. The development of the Boeing 777 commercial aircraft made extensive use
of supplier participation on cross-functional teams, enabling successful design and production in record time. Automotive manufacturers periodically give suppliers primary responsibility for designing major components, such as seating systems. The Ford Motor
Company case in Chapter 2 provides an example of a company that engages suppliers early
in the product-development process to identify opportunities for cost and quality improvements and supplier innovation.
Intellectual property issues and confidentiality are perhaps the biggest obstacles to supplier participation, particularly when new product design is involved. Some firms ask suppliers to sign confidentiality agreements to minimize the potential effect of this obstacle on
the team’s effectiveness.
Teams with Customer Participation
In an effort to be truly customer driven, some organizations include end customers on
their teams. For example, when a commercial airframe maker designs a new passenger
aircraft, it makes sense to have potential airline customers participate in the design team.
They know best the characteristics a new aircraft must have from the airline perspective,
given its anticipated passenger loads, route structures, maintenance plans, and passenger
service strategies. If supply is also included in teams with end customers, there is a greater
opportunity to deliver the greatest value in the shortest cycle time.
Co-location of Supply with Internal Customers
Locating buyers with internal customers (e.g., engineering) can help to break down barriers
between functions as individuals get to know, and learn to work with, each other. Close
proximity fosters greater awareness that leads to better understanding of the goals, strategies, and challenges of each group. Also, internal customers are more likely to involve supply in decisions if the buyer is readily accessible when questions arise. Buyers can “sell”
other departments on their worth by providing market intelligence including information
on availability, suppliers, and specific commodities. The best selling point is a measurable
outcome such as cost reduction, improved quality, or a better specification.
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Co-location of Suppliers in the Buying Organization
As organizations look for ways to do more work with fewer people and achieve the productivity and competitiveness goals of the firm, they are increasingly looking to suppliers for
expertise and assistance. Having key supplier personnel located in the buying organization
who can function as buyers, planners, and salespeople can improve buyer–seller communications and processes, absorb work typically done by the firm’s employees, and reduce
administrative and sales costs.
Supplier Councils
A number of large firms, such as General Motors and Boeing, use supplier councils to manage supplier relationships. Supplier councils usually consist of 10 to 15 senior executives
from the company’s preferred supplier base, along with six to eight of the buying firm’s top
management. Supplier councils usually meet two to four times per year and deal with supply
policy issues at the buying firm with the objectives of developing relationships and improving communication with the supply base. Supplier councils allow suppliers to be proactive
participants in the supply management activities at the buying firm and can be useful forums
to communicate strategies to key suppliers, identify problems with the supply base early on,
and agree upon competitive targets in areas such as cost, quality, and delivery.
Supply Councils
Supply councils are generally comprised of senior supply staff and are established to facilitate coordination among the business units, divisions, or plants. Many firms use supply
councils as a means of sharing information among decentralized units, or coordinating
activities focused on a specific problem that might involve several supply groups. The
goals of the council are to manage buyer–supplier relationships properly and to encourage
continuous improvement.
For example, Wellman, a manufacturer and distributor of polyester fibers and PET resins, had a decentralized supply organization, where plant purchasing reported to the local
manager at each site. The corporate purchasing council consisted of site purchasing leadership. It concentrated on standardizing purchasing processes, standardizing goods and services across sites, aggregating requirements and leveraging volume for lower prices, and
simplifying and streamlining the materials process. The council also formulated annual
business plans and objectives for purchasing.9
CONSORTIA
Purchasing consortia are a form of collaborative purchasing that is used by both public
and private-sector organizations as a means of delivering a wider range of services at a
lower total cost. Purchasing consortia can take one of several forms, ranging from informal
groups that meet regularly to discuss purchasing issues, to the creation of formal centralized consortia for the purpose of managing members’ supply activities. Consortia are quite
common in not-for-profit organizations, particularly educational institutions and health
care organizations. Interest in the concept in the for-profit sector was sparked by the ability
9
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Leenders and Johnson, Major Changes in Supply Chain Responsibilities ( Tempe, AZ: CAPS Research, 2002).
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68 Purchasing and Supply Management
to run an Internet-based consortium, called an electronic exchange or marketplace, and the
lack of antitrust obstacles (see Chapter 14).
Savings through price reductions are a primary motivation for the creation and participation in purchasing consortia. Other benefits are opportunities for staff reductions, product and service standardization, improved supplier management capabilities, specialization
of staff, and better customer service.
Despite the benefits, hesitation to participate in consortia may be due to concerns about:10
• Antitrust issues. Collaboration might be viewed as anticompetitive by the U.S. Department of Justice’s Antitrust Division and/or the Federal Trade Commission.
• Bureaucracy. The consortium may become bureaucratic, difficult to manage, and costly
to coordinate.
• Complexity. Fear that “open enrollment” will bring together buyers with widely diverse
needs and philosophies toward buyer–seller relations, resulting in untenable complexity
and dysfunction.
• Competitors. Fear that the competition might be allowed to join.
• Confidentiality. Disclosure of sensitive information. Therefore, most items purchased
through consortia are nonstrategic, such as MRO components and routine services.
• Supplier resistance. Strong suppliers may resist participating in consortium arrangements.
• Distribution channels. Some believe existing distributors provide adequate pricing and
services.
• Equality. A firm currently has preferred relationships with suppliers/free riding. The
unequal size of member organizations can create difficulties with respect to the allocation of benefits.
• Uncertainty. Some were concerned costs would not decline and service levels would.
• Standardization and compliance. The degree of uniqueness of requirements and the
costs of standardizing products and services.
• Governance. Loss of control and reporting relationships were concerns.
Successful consortia are able to address these hurdles by achieving the following six
objectives:11
1. Reducing total costs for the members through lower prices, higher quality, and better
services.
2. Eliminating and avoiding all real and perceived violations of antitrust regulations.
3. Installing sufficient safeguards to avoid real and perceived threats concerning disclosure of confidential and proprietary information.
4. Mutual and equitable sharing of risks, costs, and benefits to all stakeholders, including
buying firms/members, suppliers, and customers.
10
T. E. Hendrick, Purchasing Consortiums: Horizontal Alliances among Buying Firms Buying Common
Goods and Services ( Tempe, AZ: Center for Advanced Purchasing Studies, 1997); P. F. Johnson, “The
Pattern of Evolution in Public Sector Purchasing Consortia,” International Journal of Logistics: Research &
Applications 2, no. 1(1999), pp. 57–73.
11
T. E. Hendrick, Purchasing Consortiums: Horizontal Alliances among Buying Firms Buying Common
Goods and Services ( Tempe, AZ: Center for Advanced Purchasing Studies, 1997).
joh77899_ch03_045-075.indd 68
6/9/10 9:10 PM
Chapter 3
Supply Organization 69
5. Maintaining a high degree of trust and professionalism of the consortium stakeholders.
6. Maintaining a strong similarity among consortium members and compatibility of
needs, capabilities, philosophies, and corporate cultures.
Conclusion
There is no one perfect organizational structure for supply. Its organizational structure will
mirror the overall corporate structure. The challenge for supply executives is to maximize
the benefits of their organizational structure, whether it is centralized, decentralized, or
hybrid. Major research into organizational issues over the last decade has provided useful insights into innovative attempts to integrate the supply function and suppliers more
effectively into organizational goals and strategies. No matter where the supply function
is situated on the organization chart, each individual member of the supply organization
has the opportunity to improve relations with internal customers and suppliers in an effort
to make a greater contribution to organizational objectives.
Questions
for
Review
and
Discussion
1. Relate the objectives of supply to (1) a company producing automobiles, (2) a large
fast-food restaurant chain, and (3) a financial institution.
2. What are the challenges faced by a supply manager working in a highly centralized
structure? In a highly decentralized structure?
3. How does specialization within supply differ in small and large organizations?
4. What are the reasons for giving the CPO a title and reporting line equal to marketing,
engineering, or other key business functions?
5. What are indicators that supply is “meaningfully involved”?
6. What are the challenges in expanding the role of the CPO?
7. What implementation factors would you consider when asked to change the supply
organization from a centralized to a hybrid structure? What factors would you consider
if moving from decentralized to centralized?
8. How is team buying likely to affect the purchasing/supply function over the next decade?
9. Why and how would you go about setting up a consortium for the purchase of fuel oil,
furniture, corrugated cartons, or office supplies?
References
Fearon, Harold E., and Michiel R. Leenders. Purchasing’s Organizational Roles and
Responsibilities. Tempe, AZ: Center for Advanced Purchasing Studies, 1995.
Giunipero, Larry C.; Robert B. Handfield; and Reham Eltantawy. “Supply Management’s
Evolution: Key Skill Sets for the Supply Manager of the Future.” International Journal
of Operations and Production Management 26, no. 7, pp. 822–844.
Hendrick, Thomas E. Purchasing Consortiums: Horizontal Alliances among Firms
Buying Common Goods and Services. Tempe, AZ: Center for Advanced Purchasing
Studies, 1997.
Hendrick, Thomas E., and Jeffrey Ogden. Chief Purchasing Officers’ Compensation
Benchmarks and Demographics: A 2001 Study of Fortune 500 Firms. Tempe, AZ:
Center for Advanced Purchasing Studies, 2002.
joh77899_ch03_045-075.indd 69
6/9/10 9:10 PM
70 Purchasing
Book Title and Supply Management
Johnson, P. Fraser. “Supply Organizational Structures.” Critical Issues Report, CAPS
Research, August 2003.
Johnson, P. Fraser. “The Pattern of Evolution in Public Sector Purchasing Consortia.”
International Journal of Logistics: Research and Applications 2, no. 1 (1999),
pp. 57–73.
Johnson, P. F., and M. R. Leenders. Supply’s Organizational Roles and Responsibilities.
Tempe, AZ: CAPS Research, 2004.
Johnson, P. F., and M. R. Leenders, Supply Leadership Changes. Tempe, AZ: CAPS
Research, 2007.
Leenders, Michiel R., and P. Fraser Johnson. Major Structural Changes in Supply
Organizations. Tempe, AZ: Center for Advanced Purchasing Studies, 2000.
Leenders, Michiel R., and P. Fraser Johnson. Major Changes in Supply Chain
Responsibilities. Tempe AZ: Center for Advanced Purchasing Studies, 2002.
McCue, Cliff, and Eric Prier. “Using Agency Theory to Model Cooperative Public
Purchasing.” Journal of Public Procurement 8, no. 1, 2008, pp. 1–35.
Murphy, David J., and Michael E. Heberling. “A Framework for Purchasing and Integrated
Product Teams.” International Journal of Purchasing and Materials Management,
Summer 1996, pp. 11–19.
Nollet, Jean, and Martin Beaulieu, “Should an Organization Join a Purchasing Group?”
Supply Chain Management 10, no. 1 (2005), pp. 11–17.
Case 3–1
Iowa Elevators
Scott McBride, director of purchasing at Iowa Elevators, was reviewing information collected by his analyst, Cathy Ritchie, as he prepared for a meeting with
the executive management team scheduled for Wednesday, June 11. Scott had been asked by Walter Lettridge,
Iowa, Elevator’s CEO, to present a five-year plan for
the purchasing department at the meeting. In preparation for the meeting, Scott asked Cathy to prepare a report analyzing all expenditures made by the company
with outside suppliers over the previous year. It was
now June 3, and Scott knew there was still a lot of work
that had to be completed to get ready for the meeting the
following week.
IOWA ELEVATORS
Iowa Elevators was one of the largest grain-handling companies in the United States. Headquartered in Des Moines,
Iowa, the company had annual revenues of $2.3 billion
joh77899_ch03_045-075.indd 70
and employed more than 2,500 people. Its two business
units were the grain-handling and marketing division and
the farm supplies division.
The grain-handling and marketing division operated
approximately 300 grain elevators in the Midwest. This
division represented approximately 75 percent of total
company revenues, although total revenues had declined
by 20 percent from the previous year due to drought conditions that had affected farm crop production. Over the
previous five years, the company had invested heavily in
upgrading its elevator system to improve throughput and
increase capacity in key regions.
The farm supplies division sold crop-protection products, equipment and supplies, fertilizer, and seed through
its network of country elevators and approximately
30 marketing centers. Revenues for this division had doubled over the previous five years as part of a strategy to
tap the company’s country elevator network to diversify
its revenue base.
6/9/10 9:10 PM
Chapter 3
Iowa Elevators had a past reputation for steady financial performance and profitability. However, the company
had seen a steady decline in profitability over the previous
three years. In the most recent fiscal year, it experienced
a loss of $11 million after taxes and a sharp decline in
working capital. Management attributed its disappointing
results to lower volumes in its grain-handling and marketing division and increased competition. Despite its rising
market share, operating margins at the farm supplies division had remained flat.
Concern over the financial performance of the company led to a decision by the board of directors to make
changes to the executive team. In February, Walter
Lettridge, a veteran of the grain-handling industry, was
brought in as the new president and CEO. Shortly afterward, Jose Sousa joined Iowa Elevators as the new chief
financial officer. Both Walter and Jose had worked together at a competitor of Iowa Elevators.
Immediately after joining the company, Walter went to
work creating a major cost-cutting initiative, which would include reductions in headcounts, capital expenditure budgets,
and overhead expenses. As part of this process, Scott McBride
was asked to present a five-year plan to the executive management team, including annual cost reduction targets.
Supply Organization 71
PURCHASING AND SUPPLY
MANAGEMENT
Scott supervised a group of 11 people (see Exhibit 1) who
were responsible for the acquisition of requirements for
head office and some regional sales and administrative
offices. Its major purchases were information technology
(hardware and software); printing for forms, brochures,
and advertising; office supplies; and company automobile
leases. The only change in the purchasing organization
within the last year had been the addition of a travel coordinator as a result of a contract for air travel and car rentals. The purchasing organization was part of the corporate
services organization, which also included the human resources and information technology groups, and reported
to the CFO.
Iowa Elevators had a history of decentralized management, with individual divisions held accountable for
their own operations and bottom-line performance. As a
result, local elevator managers acted autonomously but
were responsible for local market share and profitability.
In addition, the elevator managers also made decisions
concerning the amount and variety of crop-protection
products, fertilizer, and seed stock to handle in their retail
EXHIBIT 1 Iowa Elevators Purchasing Department
Jose Sousa
CFO
Scott McBride
Director
Manager
Other Purchases & Fleet
Supervisor
Analyst
Manager IT
Purchasing
Asset
Management
Clerk
Travel
Coordinator
Cathy Ritchie
Analyst
Buyer
Assistant
Buyer
Expediting
Clerk
Invoice
Clerk
joh77899_ch03_045-075.indd 71
6/9/10 9:11 PM
72 Purchasing and Supply Management
operation. Purchases for elevator operations were handled
locally and monitored based on spending limits set in annual operating budgets.
The farm supplies division had a group of four product
managers who were responsible for the three main product segments (crop-protection products, equipment and
supplies, and fertilizer and seed). These individuals were
responsible for supplier selection, product mix, branding,
and promotion and assisted elevator and marketing center
managers in the areas of promotion, new product development, and inventory planning.
ANALYSIS OF CORPORATE SPEND
In a meeting in early May, Scott was asked by Walter
Lettridge and Jose Sousa to present his five-year plan for
the purchasing department at an executive management
team meeting on June 11. Walter had scheduled time for a
number of senior managers to present their plans and ideas
aimed at returning the company to profitability. During
the meeting, Walter commented to Scott: “I expect purchasing to deliver cost savings and your group needs to
play a more significant role in the company. You need to
explain what you can deliver and explain how you intend
to accomplish your objectives. As far as I am concerned,
EXHIBIT 2
Total
Purchases by
Category
($000)
everything is on the table right now. We need to return the
company to profitability and I am not afraid to make some
major changes in terms of how we run this business.”
Recognizing the need to present a thorough plan,
Scott enlisted the support of his analyst, Cathy Ritchie,
to help him collect and organize data. The data collection focused on two questions: (1) How much money
did Iowa Elevators spend with its outside suppliers? and
(2) How much inventory did the company carry? The data
collection process had been complicated by the variety of
management systems at different levels and at different
locations. Scott believed that, if more time had been available, Cathy might have been able to capture more spend
and inventory data.
Cathy’s analysis identified a total corporate spend of
$728 million. Although the company dealt with more than
1,500 suppliers, 20 suppliers accounted for approximately
45 percent of the total spend and the top five represented
35 percent. (The top five suppliers consisted of two railway companies and three suppliers to the farm supplies
division for crop protection and fertilizer.) She estimated
that average annual inventories in the farm supplies division were nearly $120 million with annual purchases of
$310 million. A summary of Cathy’s key findings is reported in Exhibits 2 and 3.
Spend Category
Annual Spend*
Farm supplies
Information technology and telecommunications
Fees, levies, memberships
Energy
Financial services and interest expense
Fleet
Insurance
Packaging
Professional services
MRO & construction
Transportation services
Travel and entertainment
Other
Miscellaneous and unclassified
$ 254,406
17,187
26,301
8,602
24,461
4,229
5,239
10,551
7,708
127,829
208,927
3,557
17,350
11,926
Total
$ 728,273
* Data for the most recent fiscal year.
joh77899_ch03_045-075.indd 72
6/9/10 9:11 PM
Chapter 3
EXHIBIT 3
Farm Supplies
Division
Inventory
($000)
Supply Organization 73
Category
Average Inventory
Annual Purchases
Crop protection products
Equipment and supplies
Fertilizer
Seed
$ 65,098
22,388
20,938
10,389
$ 124,696
13,743
130,557
41,787
$ 118,813
$ 310,783
Total
THE MIS PROPOSAL
Scott was aware that the MIS Group had been asked to
make a similar presentation to the executive management team. The MIS director had informed Scott that he
would be requesting $10 million in additional spending
beyond standard upgrades over the next five years with
anticipated cost savings of about $500,000 per year.
PREPARATION FOR THE MEETING
Scott viewed the upcoming meeting as an opportunity
to redefine the role of purchasing at Iowa Elevators. His
session with executive management was expected to last
approximately 90 minutes, and he wanted to prepare a
five-year plan with specific objectives for each year,
including cost reduction targets. In particular, his plan
for the coming year had to be very specific and include
identifiable projects and initiatives, schedules, project
plans, and expected costs and benefits.
As part of his proposal, Scott also wanted to establish
a budget and human resource requirements that would be
needed to support his recommendations. While he regarded
his staff as competent, Scott recognized that he would
require new managerial resources if the role of corporate
purchasing was to be expanded. Consequently, he also
planned on proposing a new organization structure and
establishing a headcount plan and budget for the purchasing department.
As Scott reviewed Cathy’s report, he began considering where he was going to start and what could be accomplished. His major concern would be resistance from the
divisions and field elevator managers, and he wondered
what, if anything, could be done to address any organizational resistance to his recommendations.
Case 3–2
Roger Haskett
On June 26, 2004, Roger Haskett, director of purchasing
for Morrow University in San Antonio, Texas, was evaluating a proposal negotiated by Professor Kahsay from the
engineering faculty to upgrade computer equipment in his
engineering lab. Roger was concerned that the proposal involved a capital lease arrangement, and even though there
was no policy to prevent capital leases from being arranged,
the university did not typically enter into such agreements.
MORROW UNIVERSITY
With more than 1,100 faculty members and almost 30,000
undergraduate and graduate students, Morrow University
was recognized as a national leader in teaching as well as
joh77899_ch03_045-075.indd 73
research. Through its 12 faculties and schools and four affiliated colleges, the university offered more than 60 different degree and diploma programs.
The purchasing department’s mandate was to maximize the value of funds spent on supplies, equipment, and
services; ensure ethical buying practices; maintain good
supplier relations; and ensure compliance with the regulations governing taxes, accounting procedures, and other
related university policies. The purchasing department
was responsible for the acquisition of all goods and services for the university except for construction contracts,
reading material offered by the library system, items offered for resale by the campus bookstore, and purchases
for the food services department.
6/9/10 9:11 PM
74 Purchasing and Supply Management
EXHIBIT 1
Capital and
Operating
Leases
Capital Leases
If any of the following criteria are met, a lease must by classified as a capital lease:
1.
2.
3.
4.
Ownership of the property is transferred to the lessee at the end of the term, or
The lease contains an option to purchase the property for less than fair market value, or
The lease term is greater than 75 percent of the property’s estimated economic life, or
The present value of the lease payments exceeds 90 percent of the fair market value of
the property.
Operating Leases
Any lease that is not a capital lease is an operating lease.
Most faculty and staff tended to handle their own purchasing needs for low-value purchases, which had been
made easier with online purchasing applications. For purchases greater than $100,000, the purchasing department
assigned a senior buyer to monitor and assist throughout
the acquisition process. Senior buyers were available from
three functional areas: business items, scientific items,
and furniture/building items.
University procedures tried to maximize purchasing
value and minimize vendor relations issues. Prior to acquiring goods or services with a value in excess of $7,500, two
written quotes were required. Three quotes were required
for acquisitions in excess of $10,000, and state policies required all acquisitions over $100,000 to be posted electronically to allow all potential vendors an opportunity to quote.
THE EQUIPMENT LEASE PROPOSAL
On June 22 the purchasing department received a proposal
from Professor Kahsay to lease eight new Curtis processors for his engineering laboratory from Menard Leasing
(Menard). The payment schedule called for an initial payment of $115,000 due on September 1, 2004; three annual
payments of $90,000 due on March 1st of each of the subsequent three years; and a purchase option of $90,000 due on
February 28, 2008. The total cost of the equipment would be
$475,000, including interest. Given the nature and size of this
request, Roger decided to deal with this request personally.
Even though there was no policy to prevent capital
leases from being arranged, the university did not typi-
joh77899_ch03_045-075.indd 74
cally enter into capital leases. In general, the purchasing
department considered capital leases an expensive and
problematic purchase arrangement that should seldom be
undertaken. Exhibit 1 describes the differences between
capital and operating leases.
In a subsequent discussion with Professor Kahsay,
Roger found out that Professor Kahsay had arranged
a capital lease because he did not have sufficient funds
within his annual operating budget to cover the cost of
purchasing the equipment outright. Roger requested that
Professor Kahsay change the lease to a purchase agreement with the equipment supplier. Roger wanted to pay
cash for the net present value of the lease—approximately
$425,000. However, Professor Kahsay was adamant that
he should handle the acquisition out of his own budget
and that any delays would jeopardize several important
research projects. He said: “This is the only way we can
stay within my budget and have the equipment arrive on
time. Several of my doctoral candidates and I have important papers due for a worldwide conference and you are
just blocking academic progress.”
DECISION
As of June 26, Roger had not yet signed the lease and both
Professor Kahsay and Pamela Switzer, from Menard, were
pressing for Roger to approve the contract (see Exhibit 2).
However, Roger felt uncomfortable with the arrangement
and wondered what action he should take.
6/9/10 9:11 PM
Chapter 3
EXHIBIT 2
Conditional
Sales Contract
Supply Organization 75
MENARD LEASING
Attn: Roger Haskett
We are pleased to present the following proposal as a basis for further discussion
concerning the financing by Menard Leasing of your planned equipment acquisitions. We
appreciate the opportunity to make this proposal to you. Menard Leasing looks forward
to working with you to complete this transaction.
LESSEE:
EQUIPMENT:
Morrow University
(2) Curtis SV1 Module with (4) 2.1 FJLOP Processors & Full Care
Warranty until February 28, 2008 (as described in attached
quotations).
TERM:
42 months, commencing September 1, 2004, or 15 days after
delivery of processors.
ESTIMATED PAYMENT: $115,000.00 due September 1, 2004, followed by 3 annual
payments of $90,000.00 commencing March 1, 2005, payable
in U.S. funds, with all applicable taxes.
ACTUAL PAYMENT:
The Estimated Monthly Payment is based on Menard’s cost of
funds on the date of this letter and, to arrive at the Actual
Monthly Payment, it will be adjusted upward or downward to
reflect changes in interest rates.
END OF LEASE
1) Purchase for $90,000.00 February, 28, 2008.
CONDITIONS:
2) The absence of any material adverse changes in the
Lessee’s financial health or creditworthiness prior to the
Funding Date.
3) The completion and due execution and delivery of
Menard’s standard form of Master Lease/Lease
Arrangement, Delivery & Acceptance Certificate and other
documents, as Menard may reasonably require, all such
documents to be in form and substance satisfactory to
Menard in all respects; such documents will supercede this
letter once executed and delivered.
4) The acceptance of this proposal by the Lessee by June 28,
2004.
5) Lessee agrees to install and accept the Equipment set forth
within ten (10) days of delivery or notify the Lessor of any
problems with the Equipment within the ten days.
Acceptance shall also be based on running the basic
hardware and software diagnostics. In addition, Lessee
agrees to accept partial shipment of the Equipment with
the understanding that partial shipment shall include an
operable system.
ACCEPTED this ________ day of June, 2004.
MENARD LEASING
joh77899_ch03_045-075.indd 75
MORROW UNIVERSITY
Pamela Switzer
(signature)
Pamela Switzer
(name/title)
6/9/10 9:11 PM
Chapter Four
Supply Processes
and Technology
Chapter Outline
The Supply Management Process
Strategy and Goal Alignment
Ensuring Process Compliance
Information Flows
Steps in the Supply Process
1. Recognition of Need
2. Description of Need
Purposes and Flow of a Requisition
Types of Requisitions
Early Supply and Supplier Involvement
3. Identification of Potential Sources
Issue an RFx
4. Supplier Selection and Determination
of Terms
5. Preparation and Placement of the
Purchase Order
6. Follow-up and Expediting
Assess Costs and Benefits
76
joh77899_ch04_076-119.indd 76
Improving Process Efficiency and
Effectiveness
A Supply Process Flowchart
Strategic Spend
Nonstrategic Spend
Information Systems and the Supply
Process
Benefits of Information Systems Technology
Technology Options
Types of Information Systems
Intranets and Extranets
Technology-Driven Efficiency and
Effectiveness
Electronic Procurement Systems
Electronic or Online Catalogs
Electronic Data Interchange (EDI)
E-Marketplaces
Online Reverse Auctions
Radio Frequency Identification (RFID)
Implications for Supply
7. Receipt and Inspection
Eliminate or Reduce Inspection
Policy and Procedure Manual
8. Invoice Clearing and Payment
Aligning Supply and Accounts
Payable
Cash Discounts and Late Invoices
Questions for Review and Discussion
9. Maintenance of Records and
Relationships
Linking Data to Decisions
Manage Supplier Relationships
Conclusion
References
Cases
4–1 Bright Technology International
4–2 Hemingway College
4–3 Portland Bus Company
6/9/10 9:12 PM
Chapter 4
Supply Processes and Technology 77
Key Questions for the Supply Decision Maker
Should we
• Use an e-procurement system to improve the efficiency of the supply process?
• Use online reverse auctions to buy nonstrategic goods and services?
• Consider establishing a supplier-managed inventory program for MRO
requirements?
How can we
• Handle lower-value purchases more efficiently?
• Streamline the process so that supply managers are more involved in the earlier
stages?
• Communicate more effectively with our internal business partners?
Identifying and streamlining key business processes to reduce costs, grow revenues, and
manage assets represents an opportunity in most organizations. Critical processes are embedded in all areas of the organization, including new product development, supply, operations, marketing, sales, and accounts payable. Managing these processes, understanding
what makes each process efficient and effective, and clarifying how each process interacts
with other processes and activities are critical to the success of the organization as a whole.
Understanding how and when to apply information technology solutions to business processes is also an ongoing challenge.
According to the CapGemini Global Chief Procurement Officer Survey, over 60 percent of total organizational spend was under the control of procurement in 65 percent of
respondents.1 While this result indicates the importance of supply in procuring a significant
portion of organizational resources, it also suggests the challenges of designing an efficient and effective process for a diverse spend. Ultimately, however, the simplest definition of supply is the exchange of money (the buyer’s responsibility) for goods and services
(the supplier’s responsibility).
The first key decision is: Which process or processes will be most effective and efficient
to support this exchange? The options for managing the information flows of a supply process have expanded along with supply management’s range of responsibilities. The nature
of the requirement will dictate the information exchanges between the purchaser and supplier. Is the purchase one-time or repetitive? How are volumes, specifications, and shipping
schedules communicated? Are the purchases part of a short-term or long-term contract?
How will prices be established and how will payment be made?
The acquisition process is closely tied to almost all other business processes and also
to the external environment, creating a need for complete information systems and crossfunctional cooperation. For example, supply must work with engineering to determine specifications, operations to determine production schedules, and finance to arrange payment.
In the past 30 years, there have been remarkable advancements in information technology
1
joh77899_ch04_076-119.indd 77
Global Chief Procurement Officer Survey 2009, CapGemini Consulting, www.capgemini.com/consulting.
6/9/10 9:12 PM
78 Purchasing and Supply Management
used in the recording, transmission, analysis, and reporting of information within organizations and their supply chain networks.
Most people recognize the strategic importance of information and knowledge management. They also recognize that technology provides tools that can improve efficiency
and effectiveness when applied appropriately to a business process. The Internet and the
availability of integrated software packages have had a substantial impact on the acquisition process and its management. Supply managers need to stay abreast of technological
developments and be able to assess the fit of each new tool with the organization’s goals
and strategy. Thus, the second key decision is: What information systems might be used to
support or enable efficient and effective processes?
This chapter focuses, first, on the critical steps of a robust supply management process,
one with structure and discipline. Once the basic supply process is understood, tools and
techniques are addressed that might improve the efficiency and effectiveness of the entire process or specific categories of spend. If the process itself is flawed, then a process
improvement program must be undertaken before the process is automated. Remember,
process first and technology last.
THE SUPPLY MANAGEMENT PROCESS
A process is a set of activities that has a beginning and an end, occurs in a specific sequence,
and has inputs and outputs. The supply management process starts with need recognition
and ends with monitoring suppliers and relationships. The steps include: recognize and describe need, identify potential sources, select source(s), determine price and terms, follow
up and expedite, receive, pay invoice, and monitor.
A process-oriented person considers the flow of information, materials, services, and capital throughout the process no matter how many functions or departments touch it. A functionally oriented person only considers the steps for which his or her department is responsible. If
supply personnel are not involved until potential sources are identified, they and the internal
business partner may miss the opportunity for supply and suppliers to add value in the need
recognition and description stages. Waste is driven into the process in the forms of unnecessary costs, long cycle times, and missed opportunities because the buying organization, operating out of functional silos, manages the process sequentially rather than simultaneously.
Five major reasons for developing a robust process are as follows:
1.
2.
3.
4.
5.
Large number of items.
Large dollar volume involved.
Need for an audit trail.
Severe consequences of poor performance.
Potential contribution to effective organizational operations inherent in the function.
Strategy and Goal Alignment
The first step in optimizing the supply process is building internal consensus around the opportunities to add value to the organization. The focus is: “Where, when, and how can supply personnel contribute to short- and long-term goals and strategies of the organization?”
Vertical and horizontal alignment of strategy and goals is required for supply to fully
contribute to the organization. Vertically, if the supply strategy at the functional or business
joh77899_ch04_076-119.indd 78
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Chapter 4
Supply Processes and Technology 79
unit level is out of sync with organizational strategy, then supply decisions will hinder
rather than assist with the achievement of organizational goals.
Horizontal alignment between and among functional areas is also required. For example, to attain profitability targets, the finance group’s cash flow goals may lead to a payment
policy that conflicts with the supply group’s goal to contribute to profitability through longterm partnerships with key suppliers in which payment terms were a key negotiating point.
Personnel at all levels must work to align strategies and goals vertically and horizontally to
maximize organizational opportunities.
Individuals from many functions play valuable roles in a successful acquisition process.
The users and specifiers of the good or service (supply’s internal customers or internal
business partners) play a role in recognizing and describing the need. They are usually
the budget owners and the primary information sources for technical descriptions, volume
requirements, and quality, delivery, and service targets.
How and when internal users communicate with supply varies. Sometimes internal customers hand off information to supply once they have clearly defined the requirement.
Other times, supply personnel bring market intelligence such as supply availability, price
trends, or new technology to the need recognition and description stages. When value
can be created in the early stages of the process, the internal business partners and supply
should interact early and often in cross-functional sourcing teams, new product or service
design teams, and commodity management teams.
Often, however, supply takes the lead role in analyzing and selecting the supplier(s)
and determining price and other terms and conditions such as payment, delivery, quality
and service. Other functional areas may step in as well. For example, expediting, shipping and receiving, legal, marketing, information systems, engineering, and accounts payable all play a role in the process, but are typically part of different functional areas with a
different reporting line than supply.
Each stakeholder has goals and objectives relative to the purchase. When these conflict,
the total cost of owning, consuming, and disposing of a purchase may increase unnecessarily. Because of this risk, many senior managers foster a process orientation through
cross-functional teams, and by creating shared or common goals, objectives, and metrics.
Ensuring Process Compliance
Increasing the rate of internal compliance with the supply process can be challenging.
Often nonsupply staff make unauthorized buying decisions (maverick buying) that lead to
higher total cost of ownership and undermine supply’s credibility internally and externally.
The root causes of noncompliance must be identified and eliminated.
Organizational structure affects process compliance. In a highly decentralized organization where supply decisions are made at the business unit, plant, or division level, supply
councils composed of site leaders may be beneficial. The council works to standardize
goods, services, and processes across sites; aggregate requirements and leverage volume
for lower prices; simplify and streamline the materials management process; formulate annual business plans; and establish objectives for supply. Without a supply council and willing participation by site supply leaders, the organization may have multiple suppliers of the
same goods and services with disparate prices, terms and conditions and varying levels of
quality and service. Even in a highly centralized organization there may be high levels of
noncompliance. Process improvements and consistent delivery of results to internal business partners may increase compliance.
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80 Purchasing and Supply Management
Organizational culture also influences process compliance. A mandate from top management to use the supply process will stop maverick buying in some organizational cultures. In
others, mandates mean little and supply personnel must persuade and convince users to comply.
Information systems may compel compliance by eliminating alternative purchasing paths,
reducing process cycle time, and instilling confidence in users that delays will be minimal.
Information Flows
There are four basic information flows involving supply.
Inward Flows (1) Information from within the organization is sent to supply, including
statements of need for materials and services. (2) Information from external sources is sent
to supply. This may come from suppliers (e.g., prices, and deliveries) or from other sources
(e.g., general market conditions and import duties).
Outward Flows (1) Information from within supply is sent to others within the organization. This includes supplier pricing, market conditions, and supply forecasts for cash flow
budgeting. (2) Information, such as requests for quotes or proposals, is sent from supply to
external sources (suppliers).
Supply must be able to manage effectively information flows involving both internal and
external partners in the supply chain. Information systems enable the efficient flow of information and support effective decision making. These tools are discussed later in this chapter.
Steps in the Supply Process
The supply process is basically a communications process. Determining what needs to
be communicated, to whom, and in what format and time frame is at the heart of an efficient and effective supply management process. It is essential for supply professionals to
determine when, where, and how they can add value and when, where, and how they can
extricate themselves from steps that are best left to other people or to technology.
The essential steps in the supply process are:
1.
2.
3.
4.
5.
6.
7.
8.
9.
Recognition of need.
Description of need.
Identification and analysis of possible sources of supply.
Supplier selection and determination of terms.
Preparation and placement of purchase order.
Follow-up and/or expediting the order.
Receipt and inspection.
Invoice clearing and payment.
Maintenance of records and relationships.
1. RECOGNITION OF NEED
A purchase originates when a person or a system identifies a definite need in the organization—what, how much, and when it is needed.
The supply department helps anticipate the needs of using departments. Supply policy
and practice may encourage or require the use of standardized items, provide procedures
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Chapter 4
Supply Processes and Technology 81
for special or unusual orders, and limit the use of rush orders. Also, since the supply
department tracks price trends and general market conditions, placing forward orders
may be essential to protect against shortage of supply or increased prices. Supply should
inform users of the normal lead time and any major changes for all standard purchased
items.
Since the greatest opportunity to affect value is when needs are recognized and described (product conception and design), the supply manager and supplier can contribute
more in these steps than later in the acquisition process. (See Chapter 6 for additional
information on value creation.) Early supply and supplier involvement, often as members
of new product development teams, provides information that may lead to cost avoidance
or reduction, faster time to market, and greater competitiveness. As discussed in Chapter 3, many organizations are turning to cross-functional teams to bring different functional
areas, and suppliers, into the process as early as possible.
2. DESCRIPTION OF NEED
The purchaser must know exactly what the internal customers want. And internal requirements should be driven by a clear understanding of the external customer’s needs. It is essential to have an accurate description of the need, whether it is a tangible good, a service,
or goods and services bundled together. Unclear or ambiguous descriptions, or overspecified materials, services, or quality levels will lead to unnecessary costs. Supply management and the user, or the cross-functional sourcing team, share responsibility for accurately
describing the item or service needed.
Purposes and Flow of a Requisition
A requisition is the document used to communicate needs internally between users/
specifiers and supply management according to established accounting controls. The flow
of the requisition is determined by who needs access to the information to perform their
duties, the need for an audit trail, and evidence of proper authorization.
A requisition is a gatekeeping tool to manage the flow of information through three
gates: (1) authority, (2) internal clarity, and (3) internal clearance.
Gate 1: Authority Does the requisitioner have the authority to make the specified
request—goods or services—and at the specified budget level? The supply department
establishes who has the power to requisition, prevents unauthorized requisitions, and communicates to suppliers that a requisition is not an order.
Gate 2: Internal Clarity Is the need described in a clear and unambiguous way? Uniform
terms or standardized commodity or service codes should be used to describe required
articles or services. The importance of proper nomenclature or commodity coding cannot
be overemphasized. The most effective way to secure this uniformity is to maintain a database of common purchased items. A coding structure that standardizes purchases brings
order and consistency and supports an efficient and effective process. A general catalog
lists all the items used, and a stores catalog lists all items carried in stock. Depending on
the technological sophistication of the organization, catalogs may be in an electronic file,
on e-catalogs, in loose-leaf form, or in a card index. Difficulties arise when supplier codes
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82 Purchasing and Supply Management
(manufacturers or service providers), industry codes, and company codes are different.
While software is available to cleanse data and apply standard coding schemas, these tools
are not perfect.
If adequately planned and properly maintained, coding schemas promote uniformity in description, reduce the number of odd sizes or grades of articles requisitioned,
and facilitate accounting and inventory procedures. If poorly planned, maintained, or
used, they may be confusing and expensive beyond their projected benefits. Convincing internal users that a standard item will suffice is an ongoing challenge for supply
personnel.
Typically only one item is included on a purchase requisition, particularly for standard
items. For special items not regularly stocked, several items may be covered by one requisition if for the same delivery date. This simplifies recordkeeping, since specific items
are secured from different suppliers, call for different delivery dates, and require separate
purchase orders and treatment.
Gate 3: Internal Clearance Descriptions should be reviewed before preparing documentation to communicate externally with potential suppliers. Quantity, based on anticipated needs, should be compared to economical quantities. The delivery date should allow
time to secure quotations and samples, if necessary, and to execute the purchase order and
obtain delivery. The requisitioner should be notified if there is a time or delivery constraint
that drives in additional expense. Consistent lack of adequate lead time is an indicator of a
process problem that must be analyzed and resolved.
This review may be performed by a buyer or a team or it may be system generated. In an
electronic or e-procurement system, preloaded data establish decision rules for requisitioning, order points, and suppliers and include triggers to send red flags for buyer review. It is
management by exception. Humans are flagged when the system detects a problem based
on thresholds set by decision makers.
For lower-value and lower-risk purchases, the buyer should question a specification
if a modification would deliver more value. For example, the buyer might recommend a
substitute if there are market shortages or lower-priced or better alternatives. A high degree
of interaction between the buyer and the user is required in the early stages of need definition because of the impact of future market conditions. At best, an inaccurate description
may result in loss of time; at worst it may have serious financial consequences and cause
disruption of supply, hard feelings internally, lost opportunity for a product or service improvement, and loss of supplier respect and trust.
Types of Requisitions
There are several types of purchase requisitions, including standard requisitions, traveling
requisitions, a bill of materials, and stores/inventory requisition.
Standard Requisition
requisition:
1.
2.
3.
4.
joh77899_ch04_076-119.indd 82
The following information should be included on a standard
Date.
Number (identification).
Originating department.
Account to be charged.
6/9/10 9:12 PM
Chapter 4
5.
6.
7.
8.
Supply Processes and Technology 83
Complete description of material or service desired and quantity.
Date material or service needed.
Any special shipping or service-delivery instructions.
Signature of authorized requisitioner.
Electronic requisitions typically have prefilled fields for standard or recurring information.
Some organizations include fields for “suggested supplier” and “suggested price.”
Traveling Requisition People have always adopted and adapted new technology to business processes. The traveling requisition was an innovation used for recurring requirements and standard parts to reduce operating expenses. In a manual system, the traveling
requisition is a form on cardstock that contains a complete description of the item. The
requisitioner sends the card to supply, indicating quantity and date needed. Supply enters
the supplier, price, and purchase order (PO) number on the traveler and sends it back to the
requisitioner, who files the card until the next reorder.
The process of determining which items are appropriate for use on a traveling requisition and the flow of the information are useful when transitioning to an automated
system.
Bill of Materials A bill of materials (BOM) simplifies the requisitioning process for
frequently needed line items in organizations that make a standard item over a relatively
long period of time.
A BOM includes all materials and parts, including allowance for scrap, to make
one end unit: for example, a two-slice toaster. Production scheduling notifies supply
of the quantity (e.g., 18,000) scheduled for production next month. Supply “explodes”
the BOM by multiplying through by 18,000 to determine the total quantity of material
needed for next month’s production. Comparison of these numbers with inventory yields
the open-to-buy figures. A materials requirement planning (MRP) or enterprise resource
planning (ERP) system is preloaded with pricing information on suppliers with longterm agreements, and order releases are generated to cover the open-to-buy amounts.
(See Chapter 8.)
Stores/Inventory Requisition Needs may be met by a material requisition from inventory
or the transfer of surplus stock from another department or division.
Early Supply and Supplier Involvement
For purchases that are of strategic or critical value to the buying organization, it is usually
advisable to manage the process through a cross-functional sourcing team (see Chapter 3).
For lower-value purchases, the buyer should question a specification if it appears that the
organization might be served better through a modification. For example, the buyer might
recommend a substitute if there are market shortages of the desired commodity or lowerpriced or better alternatives are available. Since future market conditions play such a vital
role, it makes sense to have a high degree of interaction between the supply and specifying
groups in the early stages of need definition. At best, an inaccurate description may result
in some loss of time; at worst it may have serious financial consequences and cause disruption of supply, hard feelings internally, lost opportunity for a product or service improvement, and loss of supplier respect and trust.
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84 Purchasing and Supply Management
3. IDENTIFICATION OF POTENTIAL SOURCES
Supplier selection constitutes an important part of the supply function. It involves (1) identifying potential qualified sources and (2) assessing the probability that a purchase agreement would result in on-time delivery of satisfactory product/service with appropriate
before and after sale service at lowest total cost of ownership. Supplier selection is discussed in detail in Chapter 12, “Supplier Selection.” This section addresses the tools available to communicate with potential suppliers.
Issue an RFx
When items are not covered by a contract, the buyer has four options for communicating with
potential suppliers: (1) Issue a request for information (RFI)—an optional step that is not a
solicitation for business. The three options for soliciting business are: (1) request for quotation (RFQ), (2) request for proposal (RFP), or (3) request or invitation for bid (RFB or IFB).
There are no commonly accepted definitions of these terms, so it is important for buyers
to communicate clearly to potential suppliers the analysis and selection process. Often each
solicitation tool signifies a level of complexity of the purchase, dollar value, and degree of
risk the supplier bears.
Request for Information (RFI)
An RFI is issued to gather information about potential suppliers’ products and services.
Even though the Internet enables fairly quick and easy searches, many supply organizations still prepare and send (electronically or by mail) RFIs to suppliers. An RFI is not a
solicitation for business or an offer to do business. As the name suggests, an RFI is for
information-gathering purposes only.
Solicitations The three options for soliciting business from potential suppliers are: (1)
request for quotation (RFQ), (2) request for proposal (RFP), or (3) request or invitation for
bid (RFB or IFB).
Request for Quotation (RFQ )
Typically, an RFQ is issued when there is a clear and unambiguous description of the need:
for example, a grade of material, a stock-keeping unit (SKU), or other commonly accepted
terminology. An RFQ is basically a price comparison tool for commonly used commodities sold in an open and free market where quotations can be obtained at any time.
The RFQ is a standard requisition form that includes a list of potential suppliers. It is
prepared, checked, signed, and transmitted electronically (e-procurement system, e-mail,
or fax) or mailed to potential suppliers. Quotations are recorded, the buyer selects a
supplier(s), typically on the basis of price, and a purchase order is prepared and placed with
the chosen supplier.
Request for Proposal (RFP)
An RFP is used for more complex requirements in which price is only one of several key
decision factors. Typically the buyer is planning to negotiate price and terms. An RFP
includes a detailed description of the requirement and invites bidders to use their expertise
to develop and propose one or more solutions.
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Chapter 4
Supply Processes and Technology 85
Request for Bid
A request or invitation for bid is used in a competitive bid process with or without the
opportunity to negotiate after bid receipt. A detailed bid specification package, similar to
an RFP, is developed. It is important to communicate to suppliers how the final selection
will take place. Will this be a sealed competitive bid in which the contract will be awarded
based on the lowest bid? Will the bids be the starting point from which negotiations will
take place?
4. SUPPLIER SELECTION AND DETERMINATION OF TERMS
Analysis and selection of the supplier lead to order placement. Applicable tools range from
a simple bid analysis form to complex negotiations. Supplier selection methods are discussed in Chapter 12, “Supplier Selection.” Determination of price and terms is discussed
in Chapter 9, “Delivery,” Chapter 10, “Price,” Chapter 11, “Cost Management,” and Chapter 15, “Legal and Ethics.”
5. PREPARATION AND PLACEMENT OF THE PURCHASE ORDER
A purchase order is used (see Figure 4–1) unless the supplier’s sales agreement or a release
against a blanket order is used instead. Failure to use the proper contract form may result in
serious legal complications or improper documentation. Even where an order is placed by
telephone, a confirming written order should follow. In no instance—unless it is for minor
purchases from petty cash—should materials be bought without documentation, written or
computer generated.
All companies have purchase order forms. In practice, however, all purchases are not
governed by the conditions stipulated on the purchase order. Many are governed by the
sales agreement submitted by the seller. Every company seeks to protect itself as completely as possible. Responsibilities that the purchase order form assigns to the supplier are
often transferred to the buyer in the sales agreement. Therefore, management is anxious
to use its own sales agreement when selling its products and its own purchase order form
when buying. Chapter 15 discusses the legal implications.
Format
Purchase order format and routing varies. The essential requirements are the serial number, date of issue, name and address of the supplier, the quantity and description, date of
delivery, shipping directions, price, terms of payment, and conditions governing the order.
The conditions might include:
1. Indemnification clause—to guard the buyer from damage suits caused by patent
infringement.
2. Price provisions, such as “If the price is not stated on this order, material must not be
billed at a price higher than last paid without notice to us and our acceptance thereof.”
3. A clause stating that no charges will be allowed for boxing, crating, or drayage.
4. Stipulation that the acceptance of the materials is contingent on inspection and
quality.
joh77899_ch04_076-119.indd 85
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86
Purchasing and Supply Management
FIGURE 4–1 Purchase Order
Source: Honeywell Flight Systems Division.
PURCHASE ORDER NO.
CO.
NO.
T425671–03A
DATE
3–23–92
ITEM
QUANTITY
1
150
HONEYWELL INC.
SPERRY COMMERCIAL FLIGHT SYSTEMS
P.O. BOX 52006
PHOENIX, ARIZONA 85072-2006
TERMS
4682777
1
SHIP TO: ABOVE ADDRESS UNLESS OTHERWISE NOTED
DIVISION
CM CM
2. NONTAXABLE—SERVICES
3. NONTAXABLE—PRODUCTIVE EQUIP.
Quality Control Requirements of QCS 210 apply as well
as codes noted.
General Packaging and Shipping instructions GPSI100 apply as well as specific supplier packaging codes
noted
REVLIR
DESCRIPTION
B
PRICE
ACCELEROMETER
1214.00
UNIT OF
MEASURE
4. TAXABLE—NONPRODUCTIVE GROUP
5. TAXABLE—RENTALS CONSUMABLES
DESTINATION
ACCOUNT
CONT - - SUB
COMM
CODE
PROD
CODE
4232C
17412
450
562
J.O.
DEPT
A.O. NO.
3230
EACH
This Purchase Order or Change Order including all provisions set forth hereon and any continuation sheets and
addendums and Buyer's then current Purchase Order
General Terms will be deemed as being accepted by the
Seller upon the initiation of performance hereunder. Unless specifically requested on the face hereof acknowledgement by the seller is not required.
PER REVISION LETTER SHOWN
CONFIRMED ORDER 3/20/92
THIS ORDER PLACED IN ACCORDANCE WITH A PRICING
AGREEMENT BETWEEN BUYER AND SELLER.
11132-200 (REV 1-88) HONEYWELL INC .
TAX PROJECT
CODE
CODE
ORIGIN
1. NONTAXABLE—FOR RESALE
CERT NO. 07-001648
PLUS CODE 12
PLUS CODE 988
BUYER PART NUMBER
COMPLETE PURCHASE ORDER NUMBER
BUYER PART NUMBER AND NUMBER OF
CAPTIONS OF SHIPMENT MUST APPEAR
ON ALL ADDRESS LABEL. PACKING
SLIP MUST ACCOMPANY EACH SHIPMENT.
F.O.B.
2–10–30
ADMIRAL GEAR & INSTRUMENT
2287 W. 9TH STREET
SAN MATEO, ARIZONA 85382
GPSI-100 CODES
MAIL INVOICE TO:
HONEYWELL INC.
SPERRY COMMERCIAL FLIGHT SYSTEMS
21111 N. 19TH AVENUE
PHOENIX, ARIZONA 85027-2708
PURCHASE
ORDER
34624B–30–31
QCS 210 CODES
SHIP TO:
DESTINATION
ACCOUNT
CONT - - SUB
COMM
CODE
PROD
CODE
J.O. A.O.
NO.
DEPT
By
AUTHORIZED SIGNATURE
ADDRESS ALL INQUIRIES TO:
TOTAL PRICE $182,100.00
ITEM 1
REQUISITION NO. (S)
ITEM 1 DELIVERY REQUIRED AT DESTINATION
ISSUER – – MAIL STATION
QTY.
WEEK
QTY.
WEEK
15
15
8925
8942
15
15
8930
8945
QTY.
WEEK
MISC. CODE AND SPECIAL CHARGES
21
ITEM 2
ATT.
WEEK
8920
8940
REQUISITION NO. (S)
55
WEEK
HONEYWELL INC., SPERRY COMMERCIAL
FLIGHT SYSTEMS GROUP
AIR TRANSPORT SYSTEMS DIVISION
P.O. BOX 21111
PHOENIX, ARIZONA 85036-1111
QTY.
WEEK
QTY.
WEEK
QTY.
WEEK
15
15
8932
8950
15
15
8935
15
8937
PRIORITY OR ALLOTMENT NO.
QTY.
15
CONTRACT NO. ITEM 1
43
QTY.
WEEK
QTY.
WEEK
QTY.
WEEK
QTY.
WEEK
QTY.
ISSUER
ITEM 2 DELIVERY REQUIRED AT DESTINATION
ISSUER
UNLESS
NOTED
OVERSHIPMENTS
UNACCEPTABLE
MISC. CODE AND SPECIAL CHARGES
PRIORITY OR ALLOTMENT NO.
CONTRACT NO. ITEM 2
SPLIT
IF GOVERNMENT CONTRACT NUMBER IS SHOWN THIS IS A RATED ORDER CERTIFIED FOR NATIONAL DEFENSE USE, AND YOU ARE REQUIRED
TO FOLLOW ALL THE PROVISIONS OF THE DEFENSE PRIORITIES AND ALLOCATIONS SYSTEM REGULATION (15 CFR PART 350)
5. A requirement, in case of rejection, that the seller receive a new order before
replacement is made.
6. A precise description of quality requirements and the method of quality assurance/
control.
7. Provision for cancellation of the order if deliveries are not received on the date
specified in the order.
8. A statement that the buyer refuses to accept drafts drawn against the buyer.
9. Quantity provisions for overshipments or undershipments.
10. Special interest provisions—for example, arbitration or the disposition of tools.
Routing
While a discussion about routing may seem unnecessary in the age of electronic processes, it is important to understand the flow of information. Who needs access to
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Chapter 4
Supply Processes and Technology 87
purchase order information, and why? How that information is made available, on
paper documentation or electronic files, is a matter of process design and organizational
capability.
Externally, the supplier needs the information on a PO. Giving or sending a purchase
order does not constitute a contract until it has been accepted. Typically, the supplier sends
an acknowledgment to confirm acceptance of the order and to complete the contract. What
constitutes mutual consent and the acceptance of an offer is primarily a legal question (See
Chapter 15). Without an acknowledgement, the buyer can only assume that delivery will
be made by the requested date. When delivery dates are uncertain, the buyer needs definite
information in advance to plan operations effectively.
Internally, the supply department requires access (electronically or hard copy), accounts
payable (AP) for the payment process, and receiving and/or stores to plan for and confirm
receipt and incoming inspection if required.
Blanket and Open-End Purchase Orders
Blanket or open-end purchase orders reduce costs by reducing the number of purchase
orders issued. A blanket order usually covers a variety of items. An open-end order allows
for addition of items and/or extension of time. Blanket orders are used to buy maintenance,
repair, and operations (MRO) items and production-line requirements used in volume and
purchased repetitively over a period of months.
The original purchase order contains all negotiated terms and conditions for estimated
quantities over a period of time. Subsequently, releases (See Figure 4–2) of specific
FIGURE 4–2
Blanket Order
Release
REQUISITION NO.
Source: Raytheon
Company.
RAYTHEON COMPANY
SORENSEN OPERATION
SOUTH NORWALK, CONN.
RAYTHEON
REQUISITIONED BY
UNIT
TO
BLANKET ORDER RELEASE
THIS NUMBER MUST APPEAR ON ALL
DOCUMENTS AND PACKAGES
RELEASE DATE
PURCHASE ORDER
NO.
RELEASE NO.
ACCOUNT NO.
SHIP VIA
UPS
SHIP MATERIAL TO ABOVE ADDRESS
UNLESS INDICATED OTHERWISE BELOW
DELIVER MATERIAL TO (INTERNAL)
SORENSEN
DELIVERY AT DESTINATION
VENDOR CODE
MATERIAL CODE
620393
RECEIVED
Date
Quantity
Item
Quantity
Ordered
x INDICATES CONFIRMING ORDER
DATE
YOUR
TAXABLE
DESCRIPTION
BLANKET ORDER
TERMS AND CONDITIONS
APPLY
PROD. SHOP ORDER NO.
YES
NO
X
Part Number
EXEMPTION NO.
5151175
Qty
Net Unit Price
TOTAL
RECEIVING DEPARTMENT USE ONLY
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88 Purchasing and Supply Management
quantities are made against the order. Releases may be executed by supply or, more efficiently, by production scheduling directly to the supplier. An open-end order may remain
in effect for a year, or until changes in design, material specification, or conditions affecting price or delivery necessitate renegotiations.
The Bright Technology International case at the end of this chapter illustrates a
common problem faced by many supply professionals, large numbers of orders from
suppliers for goods and services that are used regularly. An opportunity for supply in
such a situation is to reduce transaction costs by setting appropriate processes for order
placement.
Master Service Agreement (MSA)
A master service agreement is an agreement wherein the supplier(s) provides predetermined services over a specified period of time with total costs not to exceed an amount
previously agreed upon. The scope of work for each function or level of service is fully
defined and agreed upon before the period of performance starts. Costs are generally fixed
for the period of performance and usually have a “not to exceed” value. MSAs are usually
awarded for periods of one year or longer.
6. FOLLOW-UP AND EXPEDITING
After issuing a PO, the buyer may follow up and/or expedite the order.
Follow-up is routine order tracking to ensure the supplier can meet delivery promises.
An appropriate follow-up date is indicated with the order. Progress inquiries may be made
by phone, e-mail, fax, or in-person. Early notification of problems such as production
scheduling, quality, or delivery enables appropriate action. Follow-up on strategic or critical spend, especially large-dollar and/or long lead-time buys, may be about advance shipping notices (ASNs) or percentage of the production process completed as of a certain date.
Follow-up may not occur on lower-value purchases or it may be built into the electronic
supply system whereby buyers are only notified of exceptions.
Responsibility for follow-up with a services supplier may be placed in the user department to help ensure user compliance with prior commitments and deadlines. Follow-up
on internal commitments may become a joint responsibility for the supply manager as
well as the supplier. Extensive user interface with supplier personnel before and during service delivery also affects other aspects of services contract administration. For
example, if a service is performed on-site after hours, security check-in sheets and access systems may be used to verify work patterns or area activity. Periodic site visits
and a walk-through of the facility with the supplier’s representative may lead to a better
understanding of user needs. Some form of benchmarking against other providers may
also be useful.
Figure 4–3 shows a follow-up form.
Expediting is the application of pressure on a supplier to meet the original delivery
promise, to deliver ahead of schedule, or to speed up delivery of a delayed order. Threats of
order cancellation or loss of future business may be used. Expediting should be necessary
on only a small percentage of the POs issued. If the buyer has done a good job of analyzing
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Chapter 4
FIGURE 4–3
Supply Processes and Technology 89
PURCHASE ORDER FOLLOW-UP
Follow-up
Form
(Please Rush Reply)
PURCHASING DEPARTMENT • P.O. BOX 21666 • PHOENIX, ARIZONA 85036
Source: Arizona
Public Service
Company.
Date
This is our
Request
Please Answer Immediately
REPLY TO ITEMS CHECKED BELOW BY
❏ This Form
Our Purchase Order No.
Request for Quotation No.
Your Invoice No.
Date
1. RUSH SHIPMENT. ADVISE EARLIEST DATE.
Amount
❏ Wire
❏ Phone
Your Reference
16. WE HAVE NO RECORD OF TRANSACTION COVERED BY INVOICE.
ADVISE DATE OF SHIPMENT, NAME OF PERSON PLACING ORDER
AND FURNISH SIGNED DELIVERY RECEIPT COPY.
2. WHEN WILL SHIPMENT BE MADE?
IF SHIPPED. ADVISE METHOD.
17. INVOICE RETURNED HEREWITH.
3. PLEASE TRACE SHIPMENT.
18. INVOICE IS REQUIRED IN
4. IF SHIPMENT HAS BEEN MADE, MAIL INVOICE, TODAY.
COPIES.
19. PRICE OR DISCOUNT IS NOT IN ACCORDANCE WITH QUOTATION.
5. PLEASE MAIL RECEIPTED FREIGHT BILL.
20. TERMS ON INVOICE ARE NOT IN ACCORDANCE WITH THE
PURCHASE ORDER.
6. WHY DID YOU NOT SHIP AS PROMISED?
ADVISE WHEN YOU WILL SHIP.
21. ENCLOSED INVOICE SENT TO US IN ERROR.
7. WILL YOU SHIP ON DATE SHOWN ON PURCHASE ORDER?
22. DIFFERENCE IN QUANTITY.
8. RELEASE SHIPMENTS AS SHOWN UNDER REMARKS.
23. UNIT PRICE INCORRECT.
9. PLEASE MAIL US ACCEPTANCE COPY OR OUR
PURCHASE ORDER.
24. EXTENSION INCORRECT.
10. PLEASE ACKNOWLEDGE OUR ORDER.
25. PURCHASE ORDER NO. LACKING OR INCORRECT.
11. PLEASE MAKE YOUR SHIPPING DATE MORE SPECIFIC.
26. SALES TAX DOES NOT APPLY – See reverse side of Purchase Order.
12. WHEN WILL BALANCE OF ORDER BE SHIPPED.
27. SHOULD BE BILLED F.O.B. DESTINATION.
13. WHEN WILL PRICES BE SUBMITTED? PLEASE RUSH.
28. HAVE YOU CONSIDERED THIS ORDER COMPLETE?
14. PLEASE MAIL SHIPPING NOTICE.
15. PLEASE INDICATE OUR PURCHASE ORDER NUMBER ON
PAPERS REFERRED TO OR ATTACHED.
29.
Reply:
Vendor
By
510-00J
Purchasing
By
SEND WHITE AND PINK COPIES WITH CARBON INTACT.
WHITE COPY IS RETURNED WITH REPLY.
supplier capabilities, only reliable suppliers—ones who will perform according to the purchase agreement—will be selected.
Frequently, expediting is caused by poor planning inside the buying organization and
may indicate the need for internal process improvements. If material requirements planning is adequate, the buyer should not need to ask a supplier to move up the delivery date
except in unusual situations. Of course, in times of severe scarcity, the expediting activity
assumes greater importance.
Assess Costs and Benefits
One of the costs of doing business with a supplier (and vice versa) is the cost associated
with follow-up and expediting. One form of risk assessment and mitigation is matching
the degree and type of follow-up with the spend category strategy (typically based on the
importance of the purchase to the organization).
Follow-up and expediting that cost more than the value added is a form of process waste.
It should be captured and included in the total cost of ownership assessment. Expediting
may be a prime target for root cause analysis and a reduction or elimination plan. Often,
the analysis reveals that the need for expediting is driven by decisions made in the buying
organization, not by the supplier, and internal change is needed.
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7. RECEIPT AND INSPECTION
The proper receipt of goods and services is of vital importance. Many smaller and singlesite organizations have centralized receiving in one department. Often receiving reports to
supply management (see Chapter 16). If just-in-time inventory management systems have
been implemented, materials from certified suppliers or supplier partners bypass receiving
and inspection and are delivered directly to the point of use. (See Chapter 8.) Receiving
also may be bypassed for small-value purchases.
The prime purposes of receiving are to:
1.
2.
3.
4.
5.
Confirm that the order placed has actually arrived.
Check that the shipment arrived in good condition.
Ensure the quantity ordered has been received.
Forward the shipment to its proper destination (storage, inspection, or use).
Ensure that proper documentation of the receipt is registered and accessible to appropriate parties.
Shortages may occur because material has been lost in transit, short-shipped, tampered
with, or damaged in transit. Physical counts can be forced by blocking receiving from
access to the quantity ordered. If accurate amounts are entered into the system, the order
is closed out, inventory records updated, and the invoice cleared for accounts payable to
authorize payment.
Eliminate or Reduce Inspection
One goal of supply management is to ensure that quality is built in internally during the design stage and externally in the suppliers’ processes. This reduces or eliminates incoming
inspection. (See Chapter 7, “Quality,” Chapter 9, “Delivery,” and Chapter 13, “Supplier
Evaluation and Relations.”)
In a just-in-time (JIT) environment, production parts go right from the receiving dock
to production. This is only possible when the supplier is capable of achieving the right
level of quality consistently and the carrier is capable of meeting the delivery windows
consistently. When quality is not assured, incoming inspection occurs. Damage may also
occur during transit, which has implications for carrier inspection and logistics processes.
Decisions must be made about the need for inspection, the appropriate type of inspection,
and the most cost-efficient and effective method of inspection.
8. INVOICE CLEARING AND PAYMENT
An invoice is a claim against the buying organization. Typically it shows order number
and itemized price. Invoice clearance procedures are not uniform. Checks and audits of
invoices are established based on cost-benefit analysis. The cost of a person’s time to resolve minor variances may exceed the value of the variance. A decision rule may be used
that stipulates payment of the invoice as submitted, as long as the difference is within prescribed limits: for example, plus or minus 5 percent or $25, whichever is smaller. Accounts
payable tracks variances to identify suppliers that are intentionally short-shipping.
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Payment for services may vary somewhat from payment for goods. Some services require prepayment, such as an eminent speaker; some, immediately upon delivery, such as
hospitality services, whereas others can be delayed. It may be difficult for small suppliers to
offer extended payment terms, and early payment may generate price or other concessions.
Progress payments are usual for large contracts spread over time, whereas regular payments are appropriate for ongoing services such as building maintenance or food service.
Supply or accounting may be responsible for clearing invoices (see Chapter 16). If assigned to accounting, supply is relieved of a nonvalue-adding task, accounting tasks are
concentrated in a single function, and a check and balance is established between the commitment to buy and payment. If assigned to supply, immediate action can be taken because
supply placed the original order.
When the invoice is handled by accounting in a paper-based process, the following
procedure is typical:
1. Duplicate invoices are mailed directly to the accounts payable (AP) department. AP
time-stamps, checks for accuracy, and certifies for payment except where the purchase
order and the invoice differ. AP files one copy; one is returned with payment.
2. Invoices at variance with the purchase order on price, terms, or other features are referred to supply for approval.
If information is missing or does not agree with the purchase order, the invoice is returned
to the supplier for correction. Ordinarily, the buyer insists that discounts (see Chapter 10) be
computed from the receipt of the corrected invoice, not from the date originally received.
If a purchase order is cancelled and cancellation charges are paid, supply provides accounting with a “change notice” that defines the payment before approval.
If supply clears invoices, the procedure is:
1. After review and adjustments for corrections, the original invoice is forwarded to accounting to be held until supply authorizes payment. The duplicate invoice is retained
by supply.
2. When the receiving report is sent to supply, it is checked against the invoice. If the two
agree, supply keeps both documents until it receives assurance from inspection that the
goods are acceptable.
3. Supply then forwards its duplicate copy of the invoice and the receiving report to accounting, where the original copy of the invoice is already on file. Accounting issues
payment.
The three-way match of data from the purchase order, the invoice, and receiving also
occurs in an electronic procurement system.
Aligning Supply and Accounts Payable
Often, payment terms are not met. The root causes of late payment are typically either slow
cycle time in the accounts payable process or conflict between finance and supply policy.
Slow cycle time can occur because of errors on the invoice, paper-based processes, inefficient mailroom processes at the buying organization, and limited human resources in the
mailroom, accounting, and/or supply. Information systems and electronic fund transfers
may help address these problems by shortening the cycle time.
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Lack of alignment causes conflict between supply and accounting. Supply views suppliers as valuable contributors to the organization’s success. Living up to the terms and conditions of the contract is one indicator of the commitment to performance of both parties.
When buyers negotiate payment terms and their organization fails to live up to those terms,
this should be seen as a serious breach by all functional representatives.
Accounting views cash management as a primary contributor to the organization’s success. Paying accounts as late as possible allows the buying organization the use of its
money for a longer period of time. The perspective on suppliers may be that they are expendable and easily replaceable.
Management may put accounts payable and supply into one department to force goal
alignment through structure and reporting relationship. Or accounts payable and supply
may serve on a joint team to resolve inconsistencies and align processes. The Ross Wood
case in Chapter 16 illustrates how changing the accounts payable process and combining
accounts payable and supply can improve process efficiency and effectiveness.
Cash Discounts and Late Invoices
Sometimes suppliers are slow to invoice, and supply must request the invoice. Or suppliers
request payment prior to the receipt of material or services. When invoices provide for cash
discounts, do you pay the invoice within the discount period, even though the material may
not actually have been received, or do you withhold payment until the material arrives,
even at the risk of losing cash discounts?
The arguments for withholding payment of the invoice until after the goods have
arrived are:
1. Frequently the invoice does not reach the buyer until late in the discount period or after
it, if the supplier fails to invoice promptly.
2. It is poor practice to pay without an opportunity for inspection. Legally, the title to the
goods may not pass to the buyer until acceptance of them.
3. Commonly, invoices are dated on the shipment date. The buyer should state that the
discount period runs from receipt of the invoice or the goods, whichever is later.
The arguments for clearing the invoice for payment without awaiting the arrival, inspection, and acceptance of the material are:
1. The financial consideration from discounts may be substantial.
2. Failure to take the cash discounts reflects unfavorably on the credit standing of the
buyer.
3. With reputable suppliers, mutually satisfactory adjustments will be made easily.
9. MAINTENANCE OF RECORDS AND RELATIONSHIPS
The final step is to update records, including supplier performance scorecards.
Electronic files or hard copies of the order-related documents are stored or filed. Law,
accounting standards, company policy, and judgment determine which records are to be kept
and for how long. For example, a purchase order is evidence of a contract. It may be retained
much longer (normally seven years) than the requisition, which is an internal memorandum.
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The basic records to be maintained, either manually or electronically, are:
1. PO log, which identifies all POs by number and indicates the open or closed status of each.
2. PO file, containing a copy of all POs, filed numerically.
3. Commodity file, showing all purchases of each major commodity or item (date, supplier, quantity, price, PO number).
4. Supplier history file, showing all purchases placed with major large total-value suppliers.
5. Outstanding contracts against which orders are placed as required.
6. A commodity classification of items purchased.
7. A database of suppliers.
Additional record files may include:
1. Labor contracts, giving the status of union contracts (expiration dates) of all major
suppliers.
2. Tool and die record showing tooling purchased, useful life (or production quantity),
usage history, price, ownership, and location. This may prevent paying more than once
for the same tooling.
3. Minority and small business purchases, showing dollar purchases from each.
4. Bid-award history, showing which suppliers were asked to bid, amounts bid, number of
no bids, and successful bidder, by major items. This may highlight supplier bid patterns
and possible collusion.
Linking Data to Decisions
Data are collected throughout the supply management process. Turning data into usable
knowledge is a continuing challenge. From a process perspective, it is important to understand what decisions need to be made; what information is relevant; where it can be found;
and how the information will be captured, analyzed, and disseminated to decision makers.
Often the problem is information overload that leads to “analysis paralysis,” rather than
a lack of information holding up a decision. Electronic tools designed to enable better
decisions though information management are discussed later in this chapter. Metrics are
discussed in Chapter 13.
Manage Supplier Relationships
Internal and external relationships are affected throughout the supply process. They may
be initiated, developed, damaged, repaired, or ended. Relationships with key supply chain
stakeholders internally and externally should be developed and assessed throughout the
process. See Chapter 13, “Supplier Evaluation and Relations.”
IMPROVING PROCESS EFFICIENCY AND EFFECTIVENESS
Once the basic information flows and communication techniques that comprise the supply
management process are understood, we return to the initial questions: (1) What process(es)
will be most effective and efficient to support the buyer–supplier exchange? (2) What information systems might be used to support or enable efficient and effective processes?
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Purchasing and Supply Management
A Supply Process Flowchart
The flowchart in Figure 4–4 demonstrates one way an organization might improve efficiency and effectiveness of the supply management process. This begins with an assessment of the nature of the spend. Is the purchase strategic?
FIGURE 4–4 A Supply Process Flowchart
Yes
Obtain sponsorship
Is the acquisition
strategic?
No
Form cross-functional team
Define project
Use efficiency tools:
procurement card,
blanket orders,
systems contracts,
e-procurement,
online catalogs, etc.
Yes
Is the acquisition
under the small-dollar
threshold?
No
Collect and analyze data
Select supplier
Process purchase order
Yes
Is the supplier on the
Approved Supplier List?
No
Implement
Prepare specs/SOW
Measure, monitor, and report
Issue RFI (optional)
Issue RFQ, RFP, or RFB
Manage supplier relationship
Evaluate bidders
Capture and transfer best
practices
Select supplier
Implement
Measure, monitor, report
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Strategic Spend
A common definition of strategic spend is goods or services critical to the mission of the
organization. This definition allows for high- and low-dollar-value purchases. How can the
supply process for strategic spend be made more efficient (get more things done in a set
amount of time) and more effective (get more of the right things done)? And what is the
trade-off between efficiency and effectiveness?
Early Supply and Supplier Involvement
As the flowchart depicts, a cross-functional sourcing team fosters communication throughout
the process, especially during the critical stages of need recognition and description. It makes
sense to apply time, money, people and other resources to mission-critical spend. The goals are
to assure continuous availability at the lowest total cost of ownership. Information management
tools enable this communication process and support decision making. If a trade-off must be
made, typically, effectiveness is favored over efficiency in strategic spend management.
Nonstrategic Spend
For nonstrategic (nonmission-critical) purchases (the right column of the flowchart), dollar value and repetitiveness drive process decisions. First, a small dollar threshold is established and efficiency tools, especially electronic ones, are used. Second, suppliers are
prequalified and tools for efficient order placement are used.
Efficiency relates to the number of tasks performed in a set amount of time. For nonstrategic spend, efficiencies are gained by reducing the number of requisitions coming into the
supply department, the number of purchase orders issued to suppliers, and the number of
invoices and payments processed. Two continual problem areas for supply managers, small
value purchases and rush orders, are largely resolved through the use of efficiency tools.
Small Value Orders
A Pareto analysis of annual spend reveals that roughly 70 to 80 percent of transactions account for only 10 to 15 percent of spend. These are C items, typically, maintenance, repair,
and operating supplies (MRO), with low average transaction amounts. For some goods
and services that fall into this category it might be possible that the costs of processing the
order and delivering the goods or services may be greater than the value of the purchase.
The process cost to transact a $50 purchase may be as much as a $5,000 one. The goal is to
minimize the acquisition costs (the process costs not the price) of nonstrategic spend while
assuring availability.
The problem of small monetary value orders is resolved by simplifying or automating
the process or consolidating purchases to reduce the acquisition cycle time (time from
need recognition to payment), reduce administrative cost, and free up the buyer’s time for
higher-value or more critical purchases. A few examples follow:
1. Vendor/supplier-managed inventory (VMI/SMI), stockless buying, or systems contracting can be used. This is typical for MRO items. (See explanation earlier in this
chapter.)
2. A procurement card (also called a purchasing card or a P-card) is a credit card that is
provided to internal customers to purchase directly from established suppliers. (See
discussion in next section.)
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3. Supply sets up blanket orders against which internal customers issue release orders;
suppliers provide summary billing.
4. An electronic procurement or an electronic data interchange (EDI) system is used.
Ordering and reordering occur automatically based on preestablished reorder points.
5. In reverse auctions, the buyer prequalifies suppliers and invites them to an online
auction during which bidders submit bids and the buyer awards a contract for the
predefined items for a set period of time.
6. Authority levels and bidding practices are adjusted, and an e-procurement system,
telephone, fax, and auto-fax are used for ordering.
7. Integrated suppliers are used to provide a variety of supplies.
8. Low-value order placement is outsourced to third parties.
9. Persuasion may be employed to increase the number of standardized items requested.
10. Small requisitions are held until a reasonable total, in dollars, has been accumulated.
11. Specific supplies or type of supplier is assigned to a requisition calendar so that all
requests are received on the same day.
12. Invoice-less payments (self-billing) are arranged.
13. Users place orders directly with suppliers.
14. A blank check purchase order is issued in which a signed, blank check is sent along
with the PO. The supplier ships the full order, completes the check, and deposits it.
This reduces paperwork (receiving reports, inventory entries, and payments), saves
postage, often enables a larger cash discount, and saves time in accounts payable.
Reducing the Number of Requisitions Marked Rush or Emergency
Frequently, an excessive number of requisitions are marked “rush.” Emergencies, such as
style or design changes, equipment breakdowns, and unexpected changes in market conditions, may justify a rush order.
However, some “rush” orders cannot be justified. These include requisitions caused
by: (1) faulty inventory control, (2) poor production planning or budgeting, (3) lack of
confidence in the ability of the supply department to get material to the user by the proper
time, and (4) the sheer habit of marking requests “rush.” Unnecessary costs occur because
of errors from working under pressure and the impact on price to compensate the supplier
for the added burden (real or perceived) of a rush order.
Education and process improvements may reduce the problem. Supply must educate
users about the proper supply procedure and enlist the support of other functions to gain
compliance. For example, the requisitioner has to secure approval from the general manager and any extra costs that can be calculated are charged back.
Improvements in process efficiency increase the credibility of the process and the supply group. These include preapproved suppliers, purchasing cards, electronic catalogs, and
e-procurement systems that reduce lead and cycle time and allow users to issue requests
directly to a supplier against an existing contract.
Corporate Purchasing Cards
Corporate purchasing cards (also called procurement cards or P-cards) are credit cards issued to internal customers (users) in the buying organization to purchase low-dollar-value,
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high-volume goods and services. P-cards reduce administrative costs (for people, system use
and third-party providers) by reducing the number of purchase orders generated and processed
and by shortening the process cycle time for authorizing, tracking, purchasing, reconciling,
and reporting purchases. P-card use supports other process initiatives such as consolidating
spend and suppliers. They can be merged with technology to be electronic commerce compatible and data sensitive to capture information that is integrated into an ERP system.
Holders of the card are given dollar limits and lists of preferred suppliers with whom
supply has already negotiated prices and terms. P-cards automate many aspects of the system, thereby eliminating purchase orders and individual invoices and ensuring suppliers of
fast payment, two or three days versus 30+ in a typical system. By moving the transaction
activities to the user department, the supply cycle time and transaction costs are reduced.
Also, buyers (and accounts payable) are freed from the day-to-day transactions for smallvalue purchases and can focus on higher-value purchases and issues.
The primary perceived risk of P-cards is loss of control. Card issuers have instituted
controls that (1) determine, at the point of sale, if the purchase meets preset dollar limits
per card; (2) limit the number of transactions per day; (3) limit the value of a single transaction; and (4) determine if it is an approved supplier. By establishing daily and monthly
querying and reporting, the administrator manages by exception rather than focusing on
monthly statement details.
The most sophisticated card programs are able to (1) track and report sales tax information for audit purposes, (2) track and prepare 1099s for unincorporated service providers,
(3) identify whether the supplier is a minority business owner, (4) capture specific product information, (5) identify which cost center should be charged for the purchase, and
(6) include different types of purchases, including travel and entertainment expenses and
fleet expenses.
Supplier- or Vendor-Managed Inventory (SMI/VMI), Stockless
Buying, or Systems Contracting
Supplier- or vendor-managed inventory (SMI/VMI), systems contracting, or stockless buying
are more sophisticated merging of the ordering and inventory functions than blanket contracts.
Systems Contracting
Systems contracts rely on periodic billing procedures, allow nonsupply personnel to issue
order releases, employ special catalogs, and require suppliers to maintain minimum inventory levels. Normally, the volume of contract items is not specified. These systems improve
inventory turnover rates.
This technique is used most frequently in buying repetitive items such as office supplies
and maintenance, repair, and operating supplies (MRO). MRO supplies are many types of
items, all of comparatively low value and needed immediately when any kind of a plant
or equipment failure occurs. The technique is built around a blanket-type contract that is
developed in great detail regarding approximate quantities to be used in specified time
periods, prices, provisions for adjusting prices, procedures to be followed for daily requisitioning and delivery within a short time (normally 24 hours), simplified billing procedures,
and a complete catalog (often online) of all items covered by the contract.
In an electronic procurement system, the buyer or requisitioner communicates electronically each item and quantity required. If there are large-volume requirements from a
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specific supplier, the supplier stores items in the customer’s plant as though it were the supplier’s warehouse. The buyer’s contact with the supplier is electronic. The system works
as follows:
1. The buyer places the blanket order for a family of items, such as fasteners, at firm
prices.
2. The supplier delivers predetermined quantities to the inventory area set aside in the
buyer’s plant. The items are still owned by the supplier.
3. The buyer sometimes inspects the items when they are delivered.
4. The computer directs storage to the appropriate bin or shelf.
5. The buyer places POs electronically, thus relieving the supplier’s inventory records.
6. Pick sheets are computer prepared. The buyer picks the items from the supplier’s
inventory.
7. The supplier submits a single invoice monthly for all items picked.
8. The buyer’s accounting department makes a single monthly payment.
9. A summary report is electronically generated, at predetermined intervals, showing the
items and quantity used for the buyer’s and supplier’s analysis, planning, and restocking.
Systems contracting is used in service organizations as well as manufacturing and for
high-dollar-volume commodities as well as MRO supplies. The shorter cycle time from
requisition to delivery leads to substantial inventory reductions and greater compliance with
the supply process. The amount of red tape or bureaucracy is minimal. Since the user normally provides a good estimate of requirements and compensates the supplier in case the
forecast is not good, the supplier risks little in inventory investment. The degree of cooperation and information exchange required between buyer and supplier often results in stronger
relationships than normally exhibited in a traditional arm’s-length trading situation.
Vendor- or Supplier-Managed Inventory (VMI or SMI)
In VMI systems, the supplier is responsible for maintaining the buying organization’s inventory levels. The supplier has access to inventory levels (often electronically) and generates
purchase orders. Typically, the supplier manages the buyer’s inventory at the buyer’s location.
The supplier pulls stock, packs, ships, and invoices. This procedure reduces process
cycle time by reducing the number of people/functions touching the process. These systems are tools for managing small orders. VMI may also be used for consignment inventory wherein payment is made after inventory is used.
INFORMATION SYSTEMS AND THE SUPPLY PROCESS
Information systems include interconnected components that collect, process, and store
raw data and distribute information to support decision making, control, and coordination
within the organization. While information systems can be manual (paper based), most
information systems rely on information technology infrastructure, consisting of hardware
and software, to operate its information systems.
Information system technology allows organizations to be connected with important
partners in their supply chain networks. Capabilities to exchange reliable information with
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these partners quickly and cost effectively is essential for the improvement of supply chain
performance.
To determine which information systems might be used to support or enable efficient
and effective processes, it is important to understand (1) the benefits of technology, (2) the
technology options that provide these benefits, and (3) the trade-offs in costs and benefits
when choosing technology.
Benefits of Information Systems Technology
Information system technology can provide seven important benefits to the organization:
Cost reduction and efficiency gains. These can be achieved by streamlining the supply processes and freeing up supply staff to do more value-adding work.
Data accessibility. Quick and easy access to critical data in real time aids sound decision making, makes it easier to identify supply problems earlier, and provides useful
information for negotiations.
Speedier communication. Faster communication improves supply chain effectiveness
and efficiency, especially with global suppliers. Faster turnaround may increase market
share and lower inventories.
Dedicate resources to strategic issues. More resources (e.g., staff and budgets) can be
spent on strategic supply initiatives, and strategic and critical suppliers and projects
because less time is spent on administrative and tactical supply activities.
Data accuracy. Automation decreases errors, especially data entry errors. Benefits
include lower inventories (safety stock) and stockouts, lower expediting costs, and
improved customer satisfaction.
Systems integration. Integration across departments, suppliers, and customers can
provide accurate information on a timely basis to assist with production and materials
planning and decision making.
Monetary control. Enterprise systems provide control over how and where money is
spent.
Technology Options
Technology is infrastructure that serves the organization’s purposes. Selecting technology
is challenging, especially when it is changing rapidly. Several options are available:
Software
Two types of software are needed to operate the computer: operating system and applications software.
Operating system software is the interface that connects your computer and its components. Drivers (programs in the system) translate commands from the operating system
or the user into commands understood by the associated component (mouse, keyboard,
printer, video card, and CD-ROM) and back.
The three major operating systems are Windows, Unix/Linux, and Macintosh. Common
security issues are flaws (software bugs), instability, and crashes.
Applications software programs manipulate data for a specific purpose, such as analyzing supplier performance statistics and formatting a performance scorecard. Procurement
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systems are available from a variety of systems developers such as Ariba and i2. These
systems typically cover spend analysis, sourcing, contract management, procurement and
expense, invoice and payment, and supplier management. “Off-the-shelf ” purchasing software packages are constantly changing and improving.
Organizations typically have different information systems to support the specific needs
of each business process. Frequently, systems do not “talk to each other,” resulting in fragmentation of data in separate systems. Enterprise Resource Planning (ERP) systems, such
as SAP and Oracle, provide a corporate platform for information technology and include
a suite of applications such as financials, channel revenue management, human capital
management, and project management. Enterprise systems collect data from key business
processes and store it in a single comprehensive accessible data repository. Most ERP
systems offer procurement “suites.” Some companies implement specific modules, rather
than entire suites.
Applications software may be delivered on-premise or on-demand. The growth area is
on-demand.
On-premise software. Applications software that is installed and run on computers on
the premises of the person or organization using the software. Buyers incur an up-front
licensing fee and invest in the infrastructure and staff to manage and maintain the IT
system.
On-demand software—Also referred to as Software as a Service (SaaS). Applications
software, content, and services are delivered as flexible Web-based solutions. A single
software application is hosted on a remote server and accessed by multiple users through
the Internet. Users pay a subscription fee.
Service providers typically can supplement an organization’s IT staff, comanage, or
manage all applications, including legacy mainframe systems, Web-based and custom
applications, and off-the-shelf packaged solutions such as PeopleSoft, SAP, and Siebel
Systems. On-demand is a shift from a product-based to a service-based buyer–supplier
relationship.
Supply personnel can access application functionality (sourcing, contract management, procurement), research and intelligence (supply market data, category templates),
and support services (spend data cleansing, sourcing event management) as integrated
Web services. On-demand supply management applications are available from many
providers, including SAP, Oracle, Ariba, and i2.
The benefits of ERP systems have to be weighed against the costs and challenges of
implanting a new system. The Hemingway College case at the end of this chapter demonstrates the challenges faced by supply personnel in such an environment.
Types of Information Systems
Information systems can be classified into four types, each designed to serve the organization at different levels of management and across functions (see Figure 4–5). The
strategic level comprises executive support systems (ESS); management level systems
consist of management information systems (MIS) and decision support systems (DSS);
knowledge level systems include knowledge work systems (KWS) and office automation systems (OAS); and operational level systems consist of transaction processing
systems.
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FIGURE 4–5 Information Systems
Strategic Level Systems
ESS
Sales planning
Operations planning
Financial forecasts
Corporate budget
H.R. planning
MIS
Sales management
Inventory control
Capital expenditure
analysis
Annual budget
Employee relocation
analysis
DSS
Regional sales
analysis
Production scheduling
SKU profitability
analysis
Cost analysis
Union contract cost
analysis
KWS
Engineering workstations
Graphics workstations
Managerial workstations
OAS
Word processing
Document imaging
Electronic calendars
Management Level Systems
Knowledge Level Systems
Operational Level Systems
TPS
Order tracking
Machine scheduling
Securities trading
Accounts receivable
Payroll
Order processing
Material control
Cash management
Accounts payable
Employee records
Sales and Marketing
Operations
Finance
Accounting
Human Resources
Operational Level Systems These systems process data for routine operations. For supply, this includes generating POs, change orders, and requests for quotation; updating
supplier lists; and maintaining commodity prices and supplier history files. Typically,
transaction processing systems handle large volumes of repetitive data. These are the foundation of the information system hierarchy. Downtime, for only a few hours, can create
major problems.
Management Level Systems Management level systems consist of management information systems (MIS) and decision support systems (DSS).
Management information systems (MIS) provide reports and information to management to support planning, controlling, and decision making. For supply, these include departmental budget information, supplier spend analysis, supplier performance reports, and
raw material requirements forecasts.
Decision support systems (DSS) process data to assist in decision making. DSS incorporate information into an analytical framework utilizing techniques such as mathematical
relationships, simulations, or other algorithms. The outcome is definitive in nature and
presents the results in either a deterministic or probabilistic fashion. DSS typically select
alternative actions; management then considers the recommendation of the model with
other variables (that may not be quantifiable) in arriving at a final decision. Examples are
quotation analysis, price discount analysis, synthetic pricing, forecasting, and forward buying and futures trading models.
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102 Purchasing and Supply Management
Knowledge Level Systems
At the knowledge level, buyer workstations integrate a number of elements to create a
total systems package that can result in increased effectiveness and productivity. The ideal
technical components of a workstation are (1) an automated transaction system, linked to
the company’s databases, which performs routine supply activities, (2) access to decisionsupport software, (3) an expert systems element, and (4) personal productivity improvement software, word processing, spreadsheets, graphics, and database managers.
Global databases allow the consolidation of volumes and sourcing strategy. Difficulties include a significant investment, unreliable or nonexistent information networks in
some countries, differing technical standards between countries, regulatory obstacles, and
internal organizational obstacles. Considering the difficulties in coordinating efforts across
multiple business units in North America, it is easy to imagine the complications when different countries, languages, cultures, and business cultures are involved. Some companies
have adopted and implemented a single ERP system throughout global operations as a key
step in the development of global processes.
Intranets and Extranets
The Internet is used by supply professionals to search, retrieve, and read computer files worldwide; exchange e-mail and text messages globally; search databases; access government
sources; and search and purchase items from electronic catalogs, suppliers, and distributors.
An intranet is a single and widely accessible (for authorized users only) network set
up to share information and communicate with company employees. It is a private, secure
internal Web. Intranets communicate information and facilitate collaboration among employees. They can be used to display supplier catalogs, provide lists of approved suppliers,
and post company supply policies. Supply processes can be enhanced by allowing employees to place orders via Web browsers, approve and confirm purchases electronically,
and generate POs electronically. The main advantages of supply-based intranets are low
transaction costs and reduced lead times.
An extranet is a private intranet that is extended to authorized users outside the company, such as suppliers. Extranets improve supply chain coordination and information
sharing with key business partners. Through a Web-based interface, suppliers can link into
a customer’s systems and vice versa to perform any number of activities, such as check
inventory levels, track the status of invoices, or submit quotes. Because the information
exchange is electronic, supply professionals are freed to spend time on value-added activities rather than entering data or checking the status of shipments or payments.
TECHNOLOGY-DRIVEN EFFICIENCY AND EFFECTIVENESS
There are a number of technology tools available to improve process efficiency and
effectiveness.
These tools enable process effectiveness in two ways: (1) They make data more transparent, accurate, and accessible to decision makers, and (2) they relieve supply decision makers
of lower value-adding tasks. Supply managers can then focus on higher-value-adding tasks,
spend categories, and internal (other functional areas, top management) and external (suppliers) relationships. Also, the development of decision support and knowledge management
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systems enables more sophisticated modeling and facilitates more complex decisions involving multiple variables.
The primary benefit of technology is improvements in the efficiency of the supply
process. The tools addressed in this section are: e-procurement systems, online catalogs,
commodity coding schemas, EDI, e-marketplaces, radio frequency identification (RFID)
technology, and online reverse 1 auctions.
Electronic Procurement Systems
An e-procurement system is an applications software package that allows the requisitioning, authorizing, ordering, receiving, invoicing, and paying for goods and services over
the Internet. Some organizations automate from requisition-to-order and others from
requisition-to-pay. An end-to-end e-procurement system that includes contracts and
e-payables in the cycle is referred to as procure-to-pay.
The adoption of an e-procurement system is often driven by existing process inefficiency, low internal compliance, high transaction costs, low spend visibility, and low
control over organizational spend. Performance metrics for an e-procurement system
often include: (1) the percent of organizational spend under procurement (also called purchasing or supply) control, (2) requisition-to-order costs, (3) requisition-to-order cycles,
and (4) percent of off-contract (maverick) spend. Respondents to a 2007 survey by the
Aberdeen Group reported that after implementing an e-procurement system, they increased
spend under management by 35 percent, improved transaction costs by 48 percent, reduced
transaction time by 60 percent, and reduced maverick spend by 41 percent.
From the internal user/customer perspective, a successful e-procurement system is one
that makes life easier—faster ordering, faster fulfillment, and a broader range of choices.
Depending on the policies and procedures implemented, it may be possible to satisfy internal users as well as meet the requirements for internal control, cost savings, and supply
base management.
Streamlining the Receiving, Invoicing, and Payment Process
Should the e-procurement system include receiving, invoicing, and payment? A valid
question is: Does the organization need to receive an invoice? The invoice provides no
new information, yet it costs money to handle.
In an invoiceless system, suppliers are notified that payment, based on the agreed-upon cash
discount schedule, will be made in a set number of days from receipt of satisfactory merchandise (and they may specify that payment will be made only after the complete shipment has
been received). A system match between the PO, receiving report, and inspection report (if
conducted) is made, and a check is generated or funds are electronically transmitted on the receipt date at the agreed-upon payment term. The receiving report must be accurate; the PO fully
priced, including taxes and cash discount terms; and purchases must be made FOB destination,
since there is no way to enter in freight charges. The PO then is the controlling document.
For example, Microsoft developed Web-based user-friendly supply systems, compatible
with its SAP system, to address problems in accounts payable and procurement processes.
In 1996, MS Market (MSM) directed requisitioners to preapproved suppliers, provided
supplier assessments, generated POs, and provided fiscal accountability through an online
approval process. MSM also provided ordering assistance so that users with specific needs
could quickly order, clear invoices, and pay electronically.
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By 2003, MS Spend captured spend data for analysis by supplier, customer, commodity,
dollar amount, location, and 40 other categories. MS Inquire allowed payment visibility to end
users and suppliers via the Internet and provided end users with accountability in invoice approval. MS Vendor measured vendor performance and provided competencies and ratings. MS
Contract tracked Microsoft’s contractual obligations and calculated royalty and other obligation
payments. MS Expense streamlined the expense report reimbursement process and provided
online approval and coding. Cycle time was reduced to a few days versus four weeks.
The e-procurement system provided valuable information for controlling spend and
implementing cost-savings initiatives; streamlined and standardized procurement and
accounts payable processes; increased transaction velocity and visibility; and clarified
roles for users, approvers, and suppliers. Transaction costs savings included accounts
payable and invoicing staff reductions of more than 25 percent and 50 percent respectively. Approximately 20 supply people were redeployed from transactional to strategic
procurement. Microsoft estimated that the cost of processing a PO was reduced from about
$60 per transaction in 1996 to less than $5 by 2002. Transaction cost savings represented
a substantial financial impact—in fiscal year 2002 the company issued about 500,000 POs
and processed approximately 800,000 supplier invoices.2
Commodity Coding Schema
Commodity managers need commodity codes to effectively source, track, and manage
spend by category. Users, who want to get to the product quickly and easily, want robust
item descriptions that are easily searched. The procurement team must respond to the needs
of both stakeholders.
The value of a hierarchical commodity coding schema is the ability to evaluate expenditures according to any level of the hierarchy. If a company, such as an architectural,
graphic arts, or printing firm, spends a significant amount on writing utensils and supplies,
spend analysis may be at the class (ink and lead refills) or commodity (pen refills) levels.
This reveals opportunities to consolidate suppliers, find better sources, negotiate volume
discounts, or optimize the supply chain in some other way. If this spend is insignificant,
analysis may be on the higher family (office supplies) or segment (office equipment, accessories, and supplies) categories only.
The U.N. Standard Products and Services Code (UNSPSC) provides an open, global,
multisector standard for efficient, accurate classification of products and services. Some
supply managers are dissatisfied because the UNSPSC often does not address specific industries or products at a level of detail required for meaningful commodity spend analysis.
Also, it is difficult to make updates in an automated environment. Different divisions of
the same organization often assign different UNSPSC codes to the same commodity. To
effectively use UNSPSC, all databases within an organization and its supply chain need to
use the same version of UNSPSC, support backward compatibility for earlier versions, and
keep it updated. Costs can be prohibitive.
Many procurement departments use government-issued, industry-specific, or proprietary code systems that do not directly integrate or embed UNSPSC. Proprietary codes are
developed by, and useful to, a single company. Often they are not hierarchical, meaning
they lack roll-up and drill-down capabilities for spend analysis. Such coding schemas can
2
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Johnson, and M. R. Leenders, Supply Leadership Changes, Tempe (AZ: CAPS Research, March 2007).
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be expensive to develop and maintain, and it can be expensive to require trading partners
to use the same code.3
Electronic or Online Catalogs
An e-catalog or online catalog is a digitized version of a supplier’s catalog. It allows
buyers to use a Web browser to view detailed buying and specifying information about
the supplier’s products and/or services. Product catalogs include (1) product specification
data, and (2) transaction data. Product specification data describe the products and are the
same for all buyers. Transaction data (price, shipping and billing addresses, and quantity
discounts) are customized to each buyer.
Accessibility may be a factor in the supplier selection decision because it is critical to
the success of an e-procurement application. If an existing supplier lacks e-catalog capabilities, will this exclude the supplier from future business? If a supplier is developing the
capability, how much conversion time will be allowed? For a new supplier, how much
weight will this capability carry in the decision?
Suppliers have a number of options to digitize their catalogs. The buyer’s solutions’
provider can typically convert the supplier’s catalog to a suitable format. Alternatively,
the supplier can purchase an out-of-the box software package and make the conversion or
purchase the services of the software provider. Or a data aggregator can develop a library
of product specifications from a variety of suppliers and license organizations to use the
product specifications and assist in developing the transaction data. In a catalog network,
a host company collects the catalogs and customizes the transaction data for each buyer.
The buyer can either pull the catalogs onto the company server or access them from the
host company. Or the supplier may allow the buyer to “punch out” or access a supplierhosted catalog.
Supply can create buyer-controlled catalogs that combine information, such as pricing and specifications, from one or multiple suppliers. Simple database software packages
permit the creation of such catalogs, and most enterprise resource planning (ERP) systems
have features that permit the creation of customized catalogs. The supplier is responsible
for updating and maintaining the catalogs.
In-house catalogs permit the user to customize content in terms of supply options and
pricing, or to restrict supply options. These catalogs support item standardization and volume purchasing from approved suppliers. The catalog can be integrated into the company’s
system to streamline the process and track spending patterns.
Electronic Data Interchange (EDI)
EDI allows computer-to-computer exchange of business documents between two organizations using agreed standards to structure the message data. Documents exchanged via
EDI include purchase orders, shipping schedules and notifications, and invoices. EDI has
been widely adopted in the manufacturing, transportation and retailing sectors. Companies
such as Walmart, Home Depot, and Target require supplier compliance with EDI.
EDI provides secure transmission and fast turnaround of large amounts of data, greater
accuracy internally and with trading partners, shorter process cycle time that may help to
lower inventory, provide electronic logs or audit trails, and reduce administrative costs.
3
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A. E. Flynn, Catalog Management: Implementation Strategies (Tempe, AZ: CAPS Research, October 2004).
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106 Purchasing and Supply Management
There are four types of EDI:
1. A Value-Added Network (EDI VAN) is a private network for secure information exchange between companies. Each trading partner has an account with an EDI VAN that
serves as an electronic mailbox used to send and receive documents. The benefits of
an EDI VAN are convenience, an alerting service to notify of transmission or receipt,
trading partner enablement, management of outsourced EDI, and other EDI integration
services that allow companies to seamlessly use back office systems with EDI.
2. Internet EDI or AS2 (Applicability Statement 2). Two computers, a client and a server,
communicate with each other securely and reliably via the Internet. An envelope is created by AS2 and uses encryption and digital certificates to send the envelope securely.
3. Web EDI allows document exchange through an easy-to-use Web interface. Data are
converted into an EDI standard compliant format and transmitted to a trading partner.
Prepopulated forms with built-in business rules are used. Receiving, editing, and sending electronic documents are simple and efficient. The only requirement is an Internet
connection.
4. Outsourced EDI Services. The benefits are expert people, processes, and technology to operate a full-featured EDI program. This enables B2B expansion, ongoing
management, prompt integration of new trading partners, and robust infrastructure
to support transactions, translator services using current e-commerce EDI standards,
and reporting.
E-Marketplaces
Electronic marketplaces are virtual shopping malls. Business-to-business e-marketplaces
are network services on which member companies buy and sell their goods and exchange
information. Many offer a broad scope of supply chain activities, such as forecasting and
replenishment, industry standards or price discovery and clearing, and provide a range of
software solutions and consulting services. Consequently, most e-marketplaces position
themselves as “supply chain services” organizations. Members may be small, medium, or
large organizations.
The benefits of participation in an e-marketplace are the ability to aggregate spend to
benefit from economies of scale, to have visibility up and down the supply/value chain, to
automate and facilitate transactions, and to eliminate elements of the existing value chain
(disintermediation).
Biased marketplaces can be either buyer-owned or supplier-owned, whereas neutral
marketplaces are owned by independent third parties. E-marketplaces may be vertical or
horizontal. Vertical e-marketplaces focus on one specific industry. For example, Global
Healthcare Exchange (GHX) is owned by 20 organizations representing manufacturers,
distributors, hospitals, and group supply organizations. It is the largest trading exchange in
health care worldwide, operating in the United States, Canada, and nine European countries. GHX helps any organization that buys, sells, tracks, and/or uses medical products
to realize cost savings, gain efficiencies, and make better business decisions. According
to GHX (www.ghx.com) transaction volume has increased 1,500 percent since 2001,
approaching $24 billion in 2008.
Horizontal e-marketplaces offer a product or service across industries. For example,
Quadrem is a transaction delivery network that connects more than 60,000 suppliers and
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1,500 buyers and handles more than $20 billion in order throughput annually. Quadrem’s
membership includes Global 1000 buyers and suppliers from a variety of industries, as
well as suppliers of all sizes located in metropolitan, rural, and developing regions around
the world. Quadrem’s global offices provide expertise spanning technology, procurement
processes, and the change management that accompanies e-procurement initiatives.
Online Reverse Auctions
Auctions have been used for commercial transactions for centuries. Generally, auctions
are classified on the basis of competition, between sellers or buyers, and forward or descending prices. For example, the Dutch flower auctions are declining-price auctions with
competition between buyers, while a traditional English-style auction, involving the sale
of equipment or furniture, is a rising-price auction with multiple buyers. These models and
the Internet provide new techniques for determining price, quality, volume allocations, and
delivery schedules with suppliers.
Internet auction events can be open offer, private offer, posted prices, and reverse
auctions.
Open Offer Auctions Suppliers select items, see the most competitive offers from other
suppliers, and enter as many offers as they want up until a specified closing time.
Private Offer Auctions The buyer offers a target price and quantity. Suppliers enter
offer(s) on select item(s) by a specific time. The buyer evaluates and posts a “status.” The
status levels are:
Accepted: The supplier is awarded the contract, contingent on final qualification.
Closed: The supplier may no longer submit offers on the item.
BAFO (best and final offer): The supplier may submit one more offer for the item.
Open: Bidding may be continued for as many rounds as necessary to accept or close all
items.
Posted Price Auctions
gets the award.
The buyer posts the acceptable price; the first supplier to meet it
Reverse Auctions
A reverse auction is an online, real-time, dynamic, declining-price auction for goods or
services between one buying organization and a group of prequalified suppliers. Suppliers
compete by bidding against each other online using specialized software. Suppliers see the
status of their bids in real time. The supplier with the lowest bid or lowest total cost bid is
usually awarded the business.
When to Use Reverse Auctions
A reverse auction is an alternative sourcing method to RFPs/RFQs, sealed bids, face-toface negotiations, and spot buys from the commodity markets. At a minimum, the following conditions are required:
1. Clearly defined specifications, including technological, logistical, and commercial
requirements.
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108 Purchasing and Supply Management
2. A competitive market with qualified suppliers willing to participate. Typically, at least
three suppliers are required. More than six suppliers may add unnecessary costs and
complexity.
3. An understanding of the market conditions in order to set appropriate expectations for
a reserve price.
4. Buyer and seller familiarity and competency using the auction technology.
5. Clear rules of conduct: for example, conditions for extending auction length and award
criteria.
6. The buyer is prepared to switch suppliers if necessary.
7. The buyer believes that the projected savings justify a reverse auction.
Conducting Reverse Auction Events
There are three stages: preparation, the auction event, and implementation and follow-up.
Preparation The purchaser identifies or certifies appropriate suppliers; sets the quality,
quantity, delivery, and service requirements and length of contract; trains internal team
members and supplier representatives on the auction technology; tests the technology and
communicates the process and award criteria.
Event Price visibility can be handled by showing rank order, percentage, or proportional
differences. Bid ranks can be adjusted for nonprice factors, such as differences in transportation costs or quality.
Auction rules should be known up-front and strictly followed to foster credibility and
encourage future participation. Suppliers must know the length of the auction and the rules
for extending the time period. Suppliers and the buyer can typically communicate during
the auction. Messages may or may not be visible to other participants. Technical assistance
should also be available.
Implementation and Follow-up The purchaser announces the results to participants and
responds to questions. Negotiation or clarification may occur before the final contract is
signed.
The auction leader communicates the outcome internally. For example, accounting
needs to know if there is a change of suppliers and/or pricing. Anything that might improve
auctions should be documented.
Issues with Reverse Auctions
Potential ethical transgressions on behalf of buyers are:
1. Buyer knowingly accepts bids from suppliers with unreasonably low prices.
2. Buying firm submits phantom bids during the event to increase the competition
artificially.
3. Buyer includes unqualified suppliers to increase price competition.
Potential ethical issues involving suppliers are:
1. Supplier collusion.
2. Suppliers bid unrealistically low prices and attempt to renegotiate afterwards.
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3. Suppliers “bird watch” or participate in the event but do not bid to collect market intelligence. A rule requiring bids before entering the auction may preclude this behavior.
4. Suppliers submit bids after the auction event in an attempt to secure the business.
Potential Problems with Using Online Auctions4
There are a number of problems that might arise. These include:
•
•
•
•
The risk of interrupting good supplier relationships.
The risk of developing a reputation for aggressive price-buying over other considerations.
The costs of running the auction versus expected savings.
The cost savings potential of auctions versus sourcing processes such as RFP/RFQ and
negotiation.
• Significant up-front preparation and cost required compared to determining price
through an RFP/RFQ.
• Actual price when unforeseen costs are factored in versus bid price.
The Portland Bus Company at the end of this chapter provides an example of a company
that uses electronic reverse auctions and the implications for making sourcing decisions.
Radio Frequency Identification (RFID)
RFID tags contain a chip and antenna that emit a signal, using energy from a radio frequency reader, which contains information about the container or its individual contents.
RFID tags vary widely in memory, frequency, power source, and cost. The most common
are passive, read-only tags.
Employee identification badges and highway toll payment devices use RFID technology. In the early 2000s, large retailers Walmart, Tesco, and Target announced plans to
adopt RFID technology in their supply chain to reduce costs. Expected benefits include
elimination of manual counting and bar coding of incoming and outgoing material; automatic tracking of inventory levels; faster, easier, and more accurate inventory identification
and picking; and reduced spoilage through improved stock rotation. Implementation has
been slower than projected.
Implementation is challenging and costly and will take years. By 2010, implementation has varied and many suppliers and retailers do not see value at the current level of
cost and performance. RFID adds another level of information and the firm’s information systems must have the capability to capture, process, and analyze the data as they
are collected. Implementation requires investments in information technology and support
from consultants and systems engineers. Appropriate process controls are required to
achieve the benefits of inventory record accuracy.
IMPLICATIONS FOR SUPPLY
When applying technology to the acquisition process, supply professionals still play a critical decision-making role. They provide the investigative and analytical skills to source,
evaluate, and select suppliers; the influencing and persuading skills to negotiate the best
4
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P. F. Johnson, “Supply Organizational Structures,” CAPS Research, June 2003.
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110 Purchasing and Supply Management
deal for the organization; and a strategic and long-term planning approach to anticipate and
prevent problems down the road. The transactional side is streamlined and responsibility
for actually placing orders delegated to the user whenever possible.
With rapidly changing technology, it is difficult to predict what the future will look like.
It is, therefore, important to identify the key questions that decision makers in supply management must answer before embarking on an e-commerce path. These include:
1.
2.
3.
4.
5.
Should we be a leader or a follower?
What should be acquired through e-commerce?
What tools should we use to acquire those items?
Who should we use as a service provider?
Should we enter into an alliance and, if so, what type, or should we work privately?
1. Should we be a leader or a follower? Management must decide to be an early adopter
of new technology or wait to see what emerges as the norm or standard. Early adopters often report that, despite the difficulties encountered, there are advantages to being
further along than later adopters. Those who choose to wait tend to believe that the high
risks and costs associated with adopting new technology in its infancy far outweighs
whatever competitive advantages might be gained. Relevant factors are the organization’s risk aversion and success with past technology implementation.
2. What should be acquired through e-commerce? Should the organization purchase
indirect goods and services, direct requirements, or both through e-commerce tools,
strategic or nonstrategic goods and services? Supply managers must consider the characteristics of each category of purchase (see Chapter 6 for a discussion of purchases
categories) to determine what might be successfully procured online. This analysis
includes consideration of the existing and desired buyer–supplier relationship to ensure
that the method of procurement does not adversely harm the relationship.
3. What tools should we use? Streamlining tools range from lower technology tools,
such as procurement cards, to high-technology tools, such as online reverse auctions,
e-catalogs, and integrated e-RFx systems. A decision to adopt e-commerce does not
necessarily mean that all the available tools will be adopted. The decision maker must
determine the appropriateness of the tool to the type of material or service under consideration, the nature of the buyer-supplier relationship, and the comfort level of the
internal stakeholders and the suppliers.
4. Who should we use as a service provider(s)? If a third-party service provider is used, a
careful assessment must be made of the available providers. Several critical technical
issues are compatibility with, or ease of migration from, existing software; scalability
(can it grow with your needs?); the supplier’s technical reputation and experience with
supply chain management; and expertise of the staff. Some of the key considerations
beyond the technical issues are the long-term viability of the provider, user-friendliness
of the software, fee structure, and service and support—offline and online.
5. Should we enter into an alliance and, if so, what type, or should we work privately?
There are a number of alliance options available: electronic supply through a buyercontrolled system, or through a neutral, third-party-controlled e-marketplace or trading hub. A number of factors must be considered, including the technical standards
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(interoperability and ease of data exchange), the degree of trust (confidence in the provider, confidentiality of information, system reliability, and uptime), and the cost and
benefits of membership. The benefits for sellers include improved service quality from
more accurate and timely order processing, increased revenues from market expansion,
and lower costs. For the buyer, participation in e-hubs may reduce transaction costs,
increase competition through reduced search costs, and ultimately lead to lower costs.
POLICY AND PROCEDURE MANUAL
A policy and procedure manual may also contribute to the development of an efficient and
effective process. It is a carefully prepared, detailed statement of organization, duties of
the various personnel, and procedures and data systems (including illustrative forms used,
fully explained). A manual is essential for a well-conceived training program, internal
transfers, and communication about the process with nonsupply colleagues. The requirements of the Sarbanes-Oxley Act add greater importance to internal controls, standardized
processes, and consistent use.
The preparation process may reveal inconsistencies and discrepancies that lead to process improvements. Careful advance planning of the coverage, emphasis, and arrangement
is essential. It should include a clear definition of the purposes of the manual and its uses.
Both purpose and use influence length, form, and content. A manual may cover only policy
or it may include a description of the organization and some level of description of procedures. Current manuals and sample manuals from other organizations can serve as guides.
Department personnel and internal stakeholders such as design, engineering, marketing,
operations, and production should discuss and check the contents for errors and modifications. The manual should reflect the actual policy and procedures, or drive process
changes. The manual may be posted on the organization’s intranet and/or in loose-leaf
form. The chief executive officer may enhance credibility by writing a foreword defining
the supply department’s authority and endorsing its policy and procedures.
Common topics are authority to requisition; competitive bidding; approved suppliers;
supplier contracts and commitments; authority to question specifications; purchases for
employees; gifts, blanket purchase orders; confidential data; rush orders; supplier relations; lead times; determination of quantity to buy; over and short allowance procedure;
local purchases; capital equipment; personal service purchases; repair service purchases;
authority to select suppliers; confirming orders; unpriced purchase orders; documentation
for purchase decisions; invoice clearance and payment, invoice discrepancies; freight bills;
change orders; samples; returned materials; disposal of scrap and surplus; determination of
price paid; small-order procedures; salesperson interviews; and reporting of data.
Conclusion
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The supply management process has come under increasing scrutiny because of (1) the
unrelenting focus on cost management, and (2) the realization that standardized processes
and internal and external integration can lead to competitive advantage. Robust processes
are the foundation of a successful supply organization.
As supply managers continue to transition to a more strategic role in many organizations they also will continue to test and apply new technologies to the supply process.
Although current surveys indicate that overall e-commerce adoption has been slower than
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112 Purchasing and Supply Management
anticipated due to the difficulties of internal and external integration and the lack of data
standards, the future holds much promise for technology-enabled process improvements.
The challenges are great, but those who see the opportunity for cost reductions, faster
cycle times, and improved communication flows will continue to seek ways to use these
new tools to their best advantage. Information systems and information technology enable
a supply organization to contribute efficiently and effectively to organizational goals and
strategies. Without structured and disciplined supply processes, technology expenditures
may leave the organization with too many tools and not enough integration or utilization.
Questions
for
Review
and
Discussion
1. Where in the supply process is there the greatest opportunity to add value and why?
2. What are the steps in a robust supply management process?
3. What contribution to supply efficiency might be effected through the use of (a) an
e-procurement system, (b) online catalogs, and (c) online reverse auctions?
4. What approaches, other than the standard supply procedure, might be used to minimize the small-value-order problem?
5. When would you issue an RFQ rather than an RFP and why?
6. What records are needed for efficient operation of the supply function? How can data
collection throughout the process help or hurt buyer–supplier relationships?
7. What are the costs and benefits of follow-up and expediting? Are there opportunities
to reduce total cost of ownership at this stage of the process?
8. How can an e-procurement system reduce the problem of small orders? Rush orders?
9. What should be considered before switching from an existing EDI system to a Webbased system?
10. What arguments would you use to convince a supplier to participate in a reverse
auction?
11. How does the use of an e-procurement system change the nature of the skills and
knowledge required of supply management personnel?
12. What possible improvements in supply could the Internet offer in the future?
References
Beall, S. et al. The Role of Reverse Auctions in Strategic Sourcing. Tempe, AZ: CAPS
Research, 2003.
Bovet, D., and J. Martha. Value Nets: Breaking the Supply Chain to Unlock Hidden
Profits. New York: John Wiley & Sons, 2000.
DeHoratius, N. “Inventory Record Inaccuracy and RFID.” The 15th Annual North
American Research Symposium on Purchasing and Supply Management Conference
Proceedings. Tempe, Arizona, March 2004, pp. 69–76.
Farhoomand, A., and P. Lovelock. Global e-Commerce: Text and Cases. Singapore:
Pearson Education Asia, 2001.
Flynn, A. E. “Raytheon’s Buyerless Tools.” Practix 6. Tempe, AZ: CAPS Research,
March 2003.
Heijboer, G. Quantitative Analysis of Strategic and Tactical Purchasing Decisions.
Enschede, The Netherlands: Twente University Press, 2003.
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Hughes, J.; M. Ralf; and B. Michels. Transforming Your Supply Chain: Releasing Value
in Business. London: International Thomson Business Press, 1998.
Hur, D., and V. A. Mabert. “Getting the Most Out of E-Auction Investment.” The 15th
Annual North American Research Symposium on Purchasing and Supply Management
Conference Proceedings. Tempe, Arizona, March 2004, pp. 163–79.
Johnson, P. F. “Supply Organizational Structures.” Critical Issues Report. Tempe, AZ:
CAPS Research, June 2003.
Johnson, P. F., and R. D. Klassen. “e-Procurement,” MIT Sloan Management Review 46,
no. 2 (2005), pp. 7–10.
Johnson, P. F.; R. D. Klassen; M. R. Leenders; and A. Awaysheh. “Utilizing E-Business
Technologies in Supply Chains: The Impact of Firm Characteristics and Teams.”
Journal of Operations Management 25, no. 6 (2007), pp. 1255–1274.
Laudon, K. C.; J. P. Laudon; and M. E. Brabston. Management Information Systems:
Managing the Digital Firm. 4th ed. Upper Saddle River, NJ: Prentice Hall, 2008.
Percy, D. H.; L. C. Giunipero; and L. M. Dandeo. “An Analysis of E-Procurement
Strategy: What Role Does Corporate Strategy Play?” 13th Annual IPSERA Conference
Proceedings. Catania, Italy, April 2004, pp. C-216–27.
Rozemeijer, F. Creating Corporate Advantage in Purchasing. Eindhoven, The Netherlands:
Technische Universiteit Eindhoven, 2000.
Case 4–1
Bright Technology International
Bob Renwick, purchasing manager at Bright Technology International (BTI), was considering a quotation
from Electronix for supply of MJ10012 transistors, in his
Modesto, California, office. It was Tuesday, March 11,
and this was the third time this month he had been asked
to consider a volume purchase for a component; he wondered what purchasing policies, if any, he should establish
for such situations. Bob had to respond to the supplier’s
proposal before the end of the week, and he felt that the
MJ10012 transistor purchase would provide a good basis
in which to change the current approach used to acquire
similar components.
COMPANY BACKGROUND
Headquartered in Hartford, Connecticut, BTI designed,
manufactured, and marketed proprietary electro-optical
instruments. Founded in the early 1980s, BTI went public
joh77899_ch04_076-119.indd 113
in 1989. Company revenues had grown steadily and
sales for the current fiscal year were expected to reach
$10 million.
BTI’s products were used around the world for medical
research, health care, industrial process, quality control,
environmental science, and other applications. The company focused exclusively on fluorescence instrumentation
and distinguished itself in the marketplace by providing
exceptional product support.
Fluorescence was a powerful technique for studying
molecular interactions in analytical chemistry, biochemistry, cell biology, physiology, nephrology, cardiology,
photochemistry, and environmental science. Applications included studying dynamics of the folding of proteins, measuring concentrations of ions inside living cells,
studying membrane structure and function, investigating
drug interactions with cell receptors, and fingerprinting oil samples. Its advantage over other light-based
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114 Purchasing and Supply Management
investigation methods was high sensitivity, high speed,
and safety. BTI’s products included spectrofluorometers
and ratio fluorescence systems.
In recent years, the company had expanded internationally, and it currently had sales and service centers
in the United States, Canada, Germany, and the United
Kingdom. Management expected that approximately
50 percent of its sales for the coming year would be outside the United States and Canada.
BTI had nine competitors. Eight of these were about
the same size as BTI, while one other controlled nearly
one-half of the market.
In total, BTI had approximately 80 employees, including 20 in Connecticut and 45 in Modesto. Manufacturing,
engineering and R&D, and customer service functions
resided at the Modesto facility.
THE MJ10012 TRANSISTOR
The MJ10012 was a transistor used in the power supply
for several of BTI’s products. Each power supply needed
two transistors and the annual demand for this kind of
transistor had increased over the past few years. The expected demand for the coming year was estimated to be
2,000 units.
BTI had been using transistors manufactured by Steyn
Technologies. However, a competitor, Abram Industries,
acquired Steyn the previous year, and the MJ10012 transistor was no longer part of the supplier’s core product
offering; its supply was currently handled through an independent distributor, Electronix.
Checking his records, Bob found that the MJ10012
transistor had been purchased in each of the last three
years with the following price history:
PURCHASING AT BTI
Bob Renwick handled all purchasing for materials and
services related to the production of BTI’s products and
reported to the plant manager. He had a background as a
technician for a major telecom company before he joined
BTI six years earlier.
Purchased components accounted for about 80 percent of cost of sales. Although Bob worked with more
than 400 vendors, many of whom were located outside
North America, approximately three-quarters of the total dollar value for his orders were for custom-designed
components, while the balance of the orders were for
basic items. He relied heavily on members of the engineering department, who were familiar with the suitability of suppliers to satisfy technical specifications for
various components and for recommendations regarding
new suppliers.
In recent years, there had been a trend of consolidation among the manufacturers of electrical components and optical parts, and the remaining players were
mostly big companies with significant bargaining power.
While there was still price competition for high-volume
components, especially for large customers, suppliers
tended to charge a premium when supplying small custom orders. For Bob, this trend meant increased prices
for many of his components. To address this problem,
he had worked with the engineering department to redesign certain products, eliminating some costly or hardto-get components. However, engineering staff had not
been able to solve this issue completely and occasionally
customers specified certain types of subcomponents in
their orders.
joh77899_ch04_076-119.indd 114
Year
Price per Unit
Current quote
Previous year
Two years prior
Three years prior
4.95
3.50
2.00
1.69
Bob estimated that there was approximately a two
months’ supply in stock, and the supplier was quoting
lead times of 30 days.
CONCLUSION
As Bob looked at the quotation from Electronix, he considered his alternatives. He was confident that there were
other transistors on the market that provided similar performance capabilities; however, these products would
have to be located, then tested and approved by engineering. If, on the other hand, he was going to buy the transistors from Electronix, how many should he order? The
controller had indicated that it cost about $50 to process
an order, and besides, Bob felt his time was best spent on
other matters.
Bob had to make purchasing decisions about hundreds
of different parts; and although the MJ10012 transistor
decision was a minor one in terms of dollar amount, it
represented a typical issue in the purchase of electrical
and optical parts that was of growing concern to him. He
wondered whether there was anything else he could do to
deal with this and similar issues.
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Supply Processes and Technology 115
Case 4–2
Hemingway College
Catherine Barkley, manager of purchasing and accounts
payable at Hemingway College in Fresno, California,
stared at the latest e-mail from one of her staff. She had
less than three months to take her department “live” on
the new enterprise resource planning (ERP) system and
problems continued to pour in. It was now April 6 and
Catherine wondered what action she should take in light
of the tight deadline she faced. Catherine was expected to
make her recommendations to her boss, Dan Kavaliers, in
a meeting the following day.
HEMINGWAY COLLEGE
Hemingway College was a community college with approximately 12,000 students. It offered training and
educational programs in the areas of applied arts, business, health care, human services, hospitality, literacy,
academic upgrading, life skills, computers, technology,
apprenticeship, and English as a second language. All of
its 78 postsecondary certificate and diploma programs
remained popular and student intake was on the rise. The
college prized itself on its trusted position within the community, citing that almost every fifth person in the city
had passed through its classrooms.
Catherine reported to Dan Kavaliers, the vice president of finance and corporate services. She was responsible for a staff of 11 people, including four buyers, an
accounts payable manager, four accounts payable clerks,
a traffic and customs officer, and an administrative assistant. Most purchases were controlled centrally, although
some departments had recently lobbied for a more decentralized structure.
RESOURCE PLANNING SYSTEM
Two years prior, senior management at Hemingway College decided to implement a new ERP system.
Although the old systems provided the basic functionality required, they had become so antiquated and many
vendors were discontinuing support for related software
and hardware. It was also felt that this would be a good
time to integrate various areas—finance, human resources,
and student information—as well as upgrade to the latest
technology in the market.
After a seven-month supplier evaluation process, a
cross-functional senior management team, led by the
joh77899_ch04_076-119.indd 115
vice president of finance and corporate services and the
vice president of administration, selected an out-of-thebox ERP package, EduSoft, which had been successfully
installed in similar colleges across North America. The
first group to get involved in the implementation of the
new ERP system was finance, which implemented a new
general ledger, including a coding structure for the new
system. The next set of processes to be brought on the
new system were the purchasing and accounts payable
systems, because they tied in most closely with the general ledger. Successful implementation would ease the
transition of the entire purchasing module, and in turn,
that of other functional modules as well.
IMPLEMENTING THE PURCHASING
MODULE
Catherine had held her first meeting with EduSoft staff
the previous August to start planning the implementation.
As team lead for implementing the purchasing module,
she quickly realized that there were quite a few challenges
ahead. The old in-house system had gradually evolved
around the specific policies and needs of the purchasing
department. EduSoft, however, had its own functional assumptions on policies and department needs built into the
system. Catherine grappled with the issue of whether to
try and change the EduSoft system to work with old established policies or to change policies in order to leverage
EduSoft’s streamlined built-in processes that seemed to
have succeeded in other colleges.
Catherine ultimately decided to implement the new
streamlined systems, expecting that this decision would
yield substantial long-term benefits.
From October to December of the previous year, the
new purchasing and accounts payable system was tested
for the availability of features and for access and security issues. In January, process mapping from the old system to the new one was finished off, and the new system
looked set to be rolled out with all features implemented
by the end of June.
TRAINING
During January and February, Catherine started weekly
half-day meetings with staff to train them and give them
hands-on exposure to the new system. This was important,
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116 Purchasing and Supply Management
as she needed to make the staff comfortable with the new
system and achieve “buy-in.” She planned to continue
staff training throughout the summer since this was the
best time for staff to get acquainted with the new system,
because they were mostly free from the distractions of catering to everyday student requirements and issues. Currently, the staff training meetings typically lasted 15 to
20 minutes held every day or every second day, focused
around specific issues that had come up while using the
system, rather than the broad-based training sessions on
policy and process change matters held earlier. So far,
Catherine had been receiving a continual flow of problems encountered by staff trying to use the new system to
deliver the functions they wanted.
IMPLEMENTATION SCHEDULE
The current schedule called for purchasing and accounts
payable to complete implementation of its modules by the
end of June in order that its systems would be functional for
the start of the school year in August. The human resources
department was scheduled to start implementation of its
modules following purchasing, at the beginning of July, so
that employee tax and income reporting information could
start on January 1 the following year. The director of human resources and vice president of finance and corporate
services were adamant that they wanted to avoid running
two systems for employee records. Consequently, any delays in implementing the human resource modules would
in turn set back overall system implementation by one year.
Delaying implementation of the purchasing and accounts
payable modules also would create problems. Some old systems had been removed as part of the transition, and reverting back to the old systems was not viewed as feasible.
ALTERNATIVES
In order to complete implementation of her department’s
modules on schedule, Catherine felt that she had at least
two alternatives. First, Catherine believed that more staff
time was needed to implement the modules than originally budgeted. This approach would require her to increase staff overtime dramatically and add temporary
staff. Catherine would need to hold a one-week workshop
with her staff to clear up systems problems and establish
a new project plan. She estimated that staff overtime costs
would be approximately $3,000 per week and four temporary staff, at a cost of approximately $2,000 per week,
would be required. Even with the extra resources, Catherine remained concerned about the ability of her department to keep up with its normal activities, and ultimately
staff burnout, if this alternative was adopted.
A second option would be to hire consultants from
EduSoft to implement the modules. The consultants
would require some support from Catherine’s staff, but
there would be no need for additional overtime or temporary staff beyond the current budget. In her conversations
with representatives from EduSoft, they had indicated
that she should budget $12,000 per week for this service.
While this option was more convenient, Catherine was
concerned about its higher costs and the implications of
using a third party to implement the modules.
Catherine had a meeting scheduled with Dan Kavaliers
the following morning at 9:00 a.m. He was expecting an
update from her and recommendations as part of a comprehensive plan that would ensure that implementation of
the purchasing and accounts payable modules would occur by the end of June.
Case 4–3
Portland Bus Company
Richard Kaplan, buyer at Portland Bus Company (“PBC”),
in Portland, Oregon, was preparing for his meeting with
Laura Henning, business consultant for Bothe US operations, on October 14. Laura would be assisting Richard in
managing a series of reverse auctions for approximately
290 components involving seven suppliers. This would be
PBC’s first use of reverse auctions, and several important
decisions had to be made before finalizing arrangements
for the online bidding event. Before his meeting with
Laura, Richard was to review alternatives for the auction
joh77899_ch04_076-119.indd 116
process, including the type of auction to be used and the
policy for selecting suppliers.
PORTLAND BUS
PBC was owned by Dawe Motors, a leading global producer of passenger cars and commercial vehicles, headquartered in the United Kingdom. The Portland plant
assembled body shells for the Dawe Bus Division. The
shells were shipped from Portland to a facility in Medford,
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Chapter 4
Supply Processes and Technology 117
EXHIBIT 1 Supplier Profiles
Supplier
Profile
Current Spend
Dawson Manufacturing
Sheet metal and aluminum fabrication, using laser, CNC
machining and plasma cutting technologies. Facility size:
110,000 sq. ft. Subsidiary of a North American-based
automotive parts manufacturer with annual revenues of
$2 billion.
$575,000
Imperial Fabrication
Sheet metal fabrication using laser and computer integrated
systems for the design, engineering and manufacturing of
quality custom and standard products. Process capabilities:
laser cutting, welding, punching, and bending. Facility size:
100,000 sq. ft. Privately held.
$650,000
Neelin Mfg. Inc.
Contract manufacturing, machining, stamping, and assembly operations. Facility size: 80,000 sq. ft. Privately held.
Being considered for
future business
C.R.N. Products Inc.
Sheet metal fabrication, assembly, and painting for smalland high-volume production. Facility size: 60,000 sq. ft.
$210,000
Benson Sheet Metal
Stamping and punching presses, riveting, steel shearing,
tube forming, spot welding, and coating services. Facility
size: 50,000 sq. ft. Privately held.
$460,000
Beranger Enterprises
Ltd.
Light sheet metal processing and welding (1/2⬙ and thinner) as well as CNC machining and turning of carbon steel,
stainless steel, and aluminum. Facility size: 100,000 sq. ft.
Privately held.
$40,000
Camber Machining Ltd.
Machining, metal punching, and fabrication, using CNC
equipment and on-site engineering capabilities. Facility size:
50,000 sq. ft. Privately held.
$40,000
Oregon, approximately 275 miles away, for final assembly
and painting.
Approximately 550 people worked at the PBC plant.
David McGregor, director of materials, headed a staff of
12 people, who were responsible for materials planning,
inventory control, and purchasing. Total annual purchases
were approximately $250 million across five main commodity groups: fabricated metal, systems, fiber glass,
electrical, and power train. However, approximately
75 percent of purchases were set up through corporate purchasing with strategic suppliers, leaving about $60 million
to be sourced through David’s organization. Richard reported directly to David and was responsible for sourcing
fabricated metal components.
METAL COMPONENTS
During the last three months, Richard had analyzed the
company’s spend in three fabricated metal parts categories:
joh77899_ch04_076-119.indd 117
hinges, brackets, and ducts. Ten suppliers were currently
responsible for 290 different part numbers, representing
an annual spend of approximately $2 million. It had been
more than two years since a thorough review of these commodity categories had been conducted, and Richard felt
that under current market conditions, significant opportunities existed for cost savings.
Four of the PBC’s current suppliers were not in Richard’s future plans because of concerns regarding past performance. Furthermore, Richard intended to include a new
supplier, Neelin Mfg. Inc., in the online bidding event.
Exhibit 1 provides profiles of the seven suppliers that Richard was considering for participation in the reverse auction.
THE REVERSE AUCTION
Richard decided to group components into packages as
opposed to running 290 separate online bidding events.
Eventually, he settled on 21 packages of complementary
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118 Purchasing and Supply Management
EXHIBIT 2
Reverse
Auction
Packages
Package
Annual Spend ($)
7
32,551
Ducts 1
10
208,838
Ducts 2
13
106,236
Brackets 1
12
53,773
Brackets 2
12
119,912
Brackets 3
3
65,389
Brackets 4
9
111,500
Brackets 5
16
54,901
Brackets 6
13
65,997
Brackets 7
12
78,950
Brackets 8
21
48,108
Brackets 9
39
83,557
Brackets 10
15
84,630
Brackets 11
14
55,673
Brackets 12
16
64,734
Brackets 13
7
137,624
Brackets 14
2
71,675
Brackets 15
21
219,922
Brackets 16
18
133,896
Brackets 17
20
166,114
Brackets 18
Total
components, which were similar in terms of manufacturing processes, quality requirements, and production volumes (see Exhibit 2).
PBC’s parent company had a contract with Bothe AG,
an online bidding event solutions provider, to provide assistance and technical support to all of its divisions for
reverse auctions. Located in Europe, North America, and
Asia, Bothe provided a range of consulting and technology
platforms, working with approximately 200 companies in
the automotive, construction, machinery manufacturing,
and office supplies industries. Its services included online
auctions, supply contract negotiations, supplier management, and a range of Web-based technology solutions.
The Dawe passenger car division in Europe had recently
completed a reverse auction project with Bothe and was
very satisfied with the results.
joh77899_ch04_076-119.indd 118
# Part Numbers
Hinges
10
49,771
290
2,013,751
Laura Henning, business consultant for Bothe US operations, had been assigned to work with Richard to manage the reverse auction project. Laura and her team would
be responsible for:
1. Working suppliers to set up the Bothe technology
platform and providing training to their employees.
2. Communicating relevant documentation to suppliers
regarding details of the auction packages, such as
part specifications, quality requirements, and
volumes.
3. Conducting a test auction with suppliers, and subsequently addressing any technical issues or questions
that arise.
4. On the day of the auction, Bothe would monitor the
online bidding event and provide helpdesk support to
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Chapter 4
all parties involved. The Bothe platform allows the
buyer to watch the reverse auction live.
5. After the auction, Bothe would provide a detailed
auction report to the buyer, including the results,
which would be available approximately two hours
after the auction event.
Laura had indicated that once arrangements were finalized it would take a maximum of two weeks to install
the Bothe platform at the suppliers and to train their staff.
Testing the platform would take an additional one or two
days. Richard expected that suppliers would need at least
two weeks to review the packages and prepare for the
auctions. Consequently, Richard was planning to run the
auctions starting the middle of November, and he hoped
to have everything completed by the Christmas holiday.
PREPARING FOR THE REVERSE
AUCTION
The meeting on October 14 was to finalize the schedule
for the reverse auction events, review alternatives for the
auction process, including the type of auction to be used,
and set policies for selecting suppliers. Since this was
PBC’s first reverse auction, David McGregor was sensitive that any decisions might have implications for similar
projects in the future. Consequently, he expected to review Richard’s plan before proceeding.
Laura explained to Richard that there were a variety of
methods for conducting a reverse auction, and the primary
joh77899_ch04_076-119.indd 119
Supply Processes and Technology 119
decisions included visibility (e.g., what the bidders would
see during the auction), length of the auction, policies for
extending the length of the auction, and target pricing.
For example, the Bothe system could be configured such
that every bidder could see the current best price only, a
ranking of all bid prices (displayed by color codes), or the
bidder’s rank only (e.g., best, second, third, etc.). Laura
also indicated that while most auctions ran 15 or 30 minutes, it was not uncommon to have policies that extended
the event provided there was still bidding activity at the
end of the designated time. Furthermore, buyers in some
reverse auctions set target prices to provide a pricing
benchmark for bidders.
Lastly, Richard needed to decide on what basis the
packages should be awarded and to what extent prices
could be negotiated following the auction. David had
indicated to Richard that he expected a 25 percent reduction in costs as an outcome of the reverse auction
project. Richard felt that other factors needed to be
considered beyond price. For example, he recognized
that there would be costs of switching suppliers, and he
wondered how this should be taken into account when
awarding business. For example, should the lowest bidder be awarded the package if the price savings was less
than the costs of switching? Furthermore, to what extent
should PBC take into consideration long-term supply
relationships when making final sourcing decision from
the reverse auctions? Richard wanted to be clear and upfront as possible with the suppliers, some of whom he
expected may be reluctant to participate.
6/9/10 9:12 PM
Chapter Five
Make or Buy,
Insourcing, and
Outsourcing
Chapter Outline
Make or Buy
Reasons for Make instead of Buy
Reasons for Buying Outside
The Gray Zone in Make or Buy
Outsourcing Supply and Logistics
Supply’s Role in Insourcing and
Outsourcing
Conclusion
Questions for Review and Discussion
Subcontracting
References
Insourcing and Outsourcing
Cases
5–1 B&L Inc.
5–2 Rondot Automotive
5–3 Alicia Wong
Insourcing
Outsourcing
120
joh77899_ch05_120-134.indd 120
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Chapter 5
Make or Buy, Insourcing, and Outsourcing 121
Key Questions for the Supply Decision Maker
Should we
• Change the way we currently take make or buy decisions?
• Consider insourcing more?
• Outsource more?
How can we
• Improve our ability to find insourcing opportunities?
• Ensure that supply considerations receive full attention in make or buy decisions?
• Develop our outsourcing expertise better?
MAKE OR BUY
One of the most critical decisions made in any organization concerns make or buy. When
any organization starts its life, a whole series of make or buy decisions need to be made and
as the organization grows and as it adds or drops products and/or services from its offerings, make or buy decisions continue to be made. In this text the difference between make
or buy and insourcing and outsourcing is defined as follows. Insourcing refers to reversing
a previous buy decision. An organization chooses to bring in-house an activity, product, or
service previously purchased outside. Outsourcing reverses a previous make decision. Thus
an activity, product, or service previously done in-house will next be purchased. Therefore,
for any brand new product or service, make or buy decisions need to be made. Later, in
view of new internal and external circumstances, these previous make or buy decisions are
reviewed and some or all may be reversed. See Figure 5–1. Clearly, there is a major role to
play for supply managers in make or buy as well as insourcing and outsourcing.
The whole character of the organization is colored by the organization’s stance on the
make or buy decision. It is one of vital importance to an organization’s productivity and
competitiveness. Managerial thinking on this issue has changed dramatically in the last few
years with increased global competition, pressures to reduce costs, downsizing, and focus
on the firm’s core competencies. The trend is now toward buying or seeking outside suppliers for services or goods that might traditionally have been provided in-house.
Traditionally, the make option tended to be favored by many large organizations, resulting in backward integration and ownership of a large range of manufacturing and subassembly facilities. Major purchases were largely confined to raw materials, which were then
processed in-house. New management trends favoring flexibility and focus on corporate
strengths, closeness to the customer, and increased emphasis on productivity and competitiveness reinforce the idea of buying outside. It would be unusual if any one organization
were superior to competition in all aspects of manufacturing or creating services. By buying outside from capable suppliers those requirements for which the buying organization
has no special manufacturing or service advantage, the management of the buying organization can concentrate better on its main mission. With the world as a marketplace, it is
the purchaser’s responsibility to search for or develop world-class suppliers suitable for the
strategic needs of the buying organization.
joh77899_ch05_120-134.indd 121
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122 Purchasing and Supply Management
FIGURE 5–1 Make or Buy and Insourcing and Outsourcing Decisions
Business
Opportunity
What Product/Service to Create
in What Market Segment(s)?
Strategic
Entrepreneurial
Execution
What Do We Make or Buy?
Strategic
Operational
100%
Make
Later
Review
Stay
100%
Buy
Gray Zone
Change
Stay
Change
Stay
Outsource
Insource
More
Make
Insource
Gray
Zone
Change
More
Buy
Outsource
100%
Buy
Gray
Zone
100%
Make
Gray
Zone
100%
Buy
100%
Make
Gray
Zone
A recent North American phenomenon has been the tendency to purchase services outside that were traditionally performed in-house. These include security, food services, and
maintenance, but also programming, training, engineering, accounting, accounts payable,
legal, research, personnel, information systems, and even contract logistics and supply.
Thus, a new class of purchases involving services has evolved.
The make or buy decision is an interesting one because of its many dimensions. Almost
every organization is faced with it continually. For manufacturing companies, the make
alternative may be a natural extension of activities already present or an opportunity for
diversification. For nonmanufacturing concerns, it is normally a question of services rather
than products. Should a hospital have its own laundry, operate its own dietary, security,
and maintenance services, or should it purchase these outside? Becoming one’s own supplier is an alternative that has not received much attention in this text so far, and yet it is a
vital option in every organization’s supply strategy.
What should be the attitude of an organization toward this make or buy issue? Many
organizations do not have a consciously expressed policy but prefer to decide each issue as
it arises. Moreover, it can be difficult to gather meaningful accounting data for economic
analysis to support such decisions.
If it were possible to discuss the question in the aggregate for the individual firm, the
problem should be formulated in terms of: What should our organization’s objective be
in terms of how much value should be added in-house as a percentage of final product or
joh77899_ch05_120-134.indd 122
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Chapter 5
Make or Buy, Insourcing, and Outsourcing 123
service cost and in what form? A strong supply group would favor a buy tendency when
other factors are not of overriding importance.
For example, one corporation found its supply ability in international markets such
a competitive asset that it deliberately divested itself of certain manufacturing facilities
common to every competitor in the industry.
Reasons for Make instead of Buy
There are many reasons that may lead an organization to produce in-house rather than
purchase. Competitive, political, social, or environmental reasons may force an organization to make even when it might have preferred to buy. When a competitor acquires ownership of a key source of raw material, it may force similar action. Many countries insist
that a certain amount of processing of raw materials be done within national boundaries.
A company located in a high-unemployment area may decide to make certain items to
help alleviate this situation. A company may have to further process certain by-products
to make them environmentally acceptable. In each of these instances, cost may not be the
overriding concern. For additional reasons see Table 5–1.
Reasons for Buying Outside
There are many reasons why an organization may prefer to purchase goods or services
outside.
Competitive, political, social, or environmental reasons may force an organization to
buy instead of make. Government contracts may require a specified percentage of the
organization’s spend to go to minority suppliers. A process may require a large amount
of water that is scarce locally, or create difficult disposal issues in a particular location.
Frequently, certain suppliers have built such a reputation for themselves that they have
been able to build a real preference for their component as part of the finished product.
Normally, these are branded items that can be used to make the total piece of equipment
TABLE 5–1
Why Make?
joh77899_ch05_120-134.indd 123
1. The quantities are too small and/or no supplier is interested or available in providing
the goods.
2. Quality requirements may be so exacting or so unusual as to require special
processing methods that suppliers cannot be expected to provide.
3. Greater assurance of supply or a closer coordination of supply with the demand.
4. To preserve technological secrets.
5. To obtain a lower cost.
6. To take advantage of or avoid idle equipment and/or labor.
7. To ensure steady running of the corporation’s own facilities, leaving suppliers to bear
the burden of fluctuations in demand.
8. To avoid sole-source dependency.
9. To reduce risk.
10. The purchase option is too expensive.
11. The distance from the closest available supplier is too great.
12. A significant customer required it.
13. Future market potential for the product or service is expanding rapidly.
14. Forecasts of future shortages in the market or rising prices.
15. Management takes pride in size.
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124 Purchasing and Supply Management
TABLE 5–2
Why Buy?
1. The organization may lack managerial or technical expertise in the production of the
items or services in question.
2. Lack of production capacity. This may affect relations with other suppliers or
customers as well.
3. To reduce risk.
4. The challenges of maintaining long-term technological and economic viability for a
noncore activity.
5. A decision to make, once made, is often difficult to reverse. Union pressures and
management inertia combine to preserve the status quo. Thus, buying outside is seen
as providing greater flexibility.
6. To assure cost accuracy.
7. There are more options in potential sources and substitute items.
8. There may not be sufficient volume to justify in-house production.
9. Future forecasts show great demand or technological uncertainty, and the firm is
unable or unwilling to undertake the risk of manufacture.
10. The availability of a highly capable supplier nearby.
11. The desire to stay lean.
12. Buying outside may open up markets for the firm’s products or services.
13. The ability to bring a product or service to market faster.
14. A significant customer may demand it.
15. Superior supply management expertise.
more acceptable to the final user. The manufacturers of transportation construction or mining equipment frequently let the customer specify the power plant brand and see this option
as advantageous in selling their equipment. For additional reasons see Table 5–2.
The arguments advanced for either side of the make or buy question sound similar: better quality, quantity, delivery, price/cost, service, lower risk, greater opportunity to contribute to the firm’s competitive position and ability to provide greater customer satisfaction.
Therefore, each individual make or buy decision requires careful analysis of both options.
Even in the make decision, there will likely be a significant supply input requirement and
there is even a greater one on the buy option. Thus, supply managers are constantly required to provide information, judgments, and expertise to assist the organization in resolving make or buy decisions wisely.
The Gray Zone in Make or Buy
Research by Leenders and Nollet suggests that a “gray zone” may exist in make or buy
situations. There may be a range of options between 100 percent make or 100 percent buy.
(See Figure 5–1.) This middle ground may be particularly useful for testing and learning
without having to make the full commitment to make or buy. Particularly in the purchase of
services, where no equipment investment is involved, it may be that substantial economies
accrue to the organization that can substitute low-cost internal labor for expensive outside
staff or low-cost external labor for expensive inside staff.
A good example of a gray zone trade-off in the automotive industry is the supplier who
takes over design responsibility for a component from the car manufacturer. In maintenance, some types of servicing can be done by the purchaser of the equipment, other types
by the equipment manufacturer.
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The gray zone in make or buy may offer valuable opportunities or superior options for
both purchaser and supplier.
SUBCONTRACTING
A special class of the make or buy spectrum is the area of subcontracting. Common in
military and construction procurement, subcontracts can exist only when there are prime
contractors who bid out part of the work to other contractors, hence the term subcontractor.
In its simplest form, a subcontract is a purchase order written with more explicit terms and
conditions. Its complexity and management varies in direct proportion to the value and size
of the program to be managed. The management of a subcontract may require unique skills
and abilities because of the amount and type of correspondence, charts, program reviews,
and management reporting that are necessary. Additionally, payment may be handled differently and is usually negotiated along with the actual pricing and terms and conditions
of the subcontract.
The use of a subcontract is appropriate when placing orders for work that is difficult
to define, will take a long period of time, and will be extremely costly. For example,
aerospace companies subcontract many of the larger structural components and avionics.
Wings, landing gears, and radar systems are examples of high-cost items that might be
purchased on a subcontract. The subcontract is normally administered by a team that might
include: a subcontract administrator (SCA), an equipment engineer, a quality assurance
representative, a reliability engineer, a material price/cost analyst, a program office representative, and/or an on-site representative.
Managing the subcontract is a complex activity that requires knowledge about performance to date as well as the ability to anticipate actions needed to ensure the desired end
results. The SCA must maintain cost, schedule, technical, and configuration control from
the beginning to the completion of the task.
Cost control of the subcontract begins with the negotiation of a fair and reasonable
cost, proper choice of the contract type, and thoughtfully imposed incentives. Schedule
control requires the development of a good master schedule that covers all necessary contract activities realistically. Well-designed written reports and recovery programs, where
necessary, are essential. Technical control must ensure that the end product conforms
to all the performance parameters of the specifications that were established when the
contract was awarded. Configuration control ensures that all changes are documented.
Good configuration control is essential to “aftermarket” and spares considerations for the
product. Unlike a normal purchase order of minimal complexity, where final closeout may
be accomplished by delivery and payment, a major subcontract involves more definite
actions to close. These actions vary with the contract type and difficulty of the item/task
being procured. Quite often large and complex procurements require a number of changes
during the period of performance. These changes result in cost claims that must be settled
prior to contract closure. Additionally, any tooling or data supplied to the contractor to
support the effort must be returned. All deliverable material, data, and reports must be
received and inspected. Each subcontract’s requirements will vary in the complexity of the
closure requirements; however, in all cases a subcontract performance summary should
be written to provide a basis for evaluation of the supplier for future bidder or supplier
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126 Purchasing and Supply Management
selection. Such a report also is necessary in providing information for subsequent claims
or renegotiation.
INSOURCING AND OUTSOURCING
Insourcing and outsourcing occur when the decisions are made to reverse past make or buy
decisions. Just because the decision to make or buy was properly made originally, this does
not mean it cannot be changed. New circumstances inside the organization, in the market,
or in the environment may require the organization to reverse its stance on a previous make
or buy decision.
If the previous decision to make or buy was improperly made and can be corrected
subsequently, this should obviously be done. However, the arguments for constantly reassessing past make or buy decisions are particularly strong. Perceived risks may have been
minimized or eliminated. New technology may permit processes previously considered
impossible. New suppliers may have entered the market or old suppliers may have left.
New trade-offs between raw materials and components, such as substitution of steel by
plastic, may result in new options. It is this constant change in volumes, prices, capabilities,
specifications, suppliers, capacities, regulations, competitors, technology, and managers
that requires supply managers to review their current make and buy profile continuously in
identifying new strengths and weaknesses, opportunities, and threats.
The two questions that need to be addressed on an ongoing basis by a cross-functional
team including supply, operations, accounting and marketing are: (1) Which products or
services are we currently buying that we should be doing in-house? (2) Which products and
services that we are currently doing in-house should we be buying outside?
INSOURCING
Insourcing, the often forgotten twin of outsourcing, deals with past buy decisions that are
reversed. Given the demands on procurement managers’ time, the likelihood that supply
managers will initiate an insourcing initiative is relatively small. Continuing to buy what
was purchased before is likely to be standard practice. From a supply perspective there are,
however, several reasons why supply might have to trigger an insourcing initiative. The
most obvious reason is when an existing source of supply goes out of business or drops a
product or service line and no other supplier is available. Assuming the requirement for
product or service continues, the supply manager needs to find an alternate source. Supplier
development or the creation of a new supplier who was previously not selling the product
or service is one option. The other is to insource. Similarly, a sudden massive increase
in price, the purchase of a sole source by a competitor, political events and regulatory
changes, or a lack of supply of a key raw material or component required for the manufacture of the purchased product might force supply to consider insourcing. Thus, anything
that threatens assurance of supply may provide supply a reason for insourcing. This might
be called the necessity argument: “We would prefer not to produce this product or service
in-house, but we really don’t have any other options.”
There are other organizational factors, however, aside from the aforementioned supply
considerations, that may make insourcing an attractive option. The reasons would be similar
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to the “make” arguments provided earlier in this chapter in the make or buy discussion.
We may have developed a unique process for this product or service. Our quality, delivery,
total cost of ownership, or flexibility would be vastly improved. We could provide superior
customer service and satisfaction. Insourcing would greatly enhance our competitive ability. This might be called the opportunity argument: “We would prefer to do this in-house
because it would give us a strategic competitive advantage.”
After the decision to insource has been taken, the smooth transition from outside supply to inside manufacture will require supply’s special attention. In the first place, how
do we discontinue our dealings with our existing supplier(s)? Can the change-over occur
simultaneously with current contract expiries or may penalties have to be paid to terminate
existing commitments?
With any insourcing initiatives, there is also a new supply issue in terms of raw materials, components, equipment, energy, and services required to produce the particular
requirement just insourced. Therefore, supply’s capability to provide the required inputs
competently is one of the factors to be considered in any insourcing decision.
The Alicia Wong case at the end of this chapter is an interesting example of an insourcing decision. This case describes the opportunity to produce mustard in-house, rather than
purchasing it from an outside supplier. Because mustard is used in many products, the
decision focuses not only on whether this insourcing is an attractive proposition, but also,
if the decision is to go ahead, how to ensure it will be successful.
OUTSOURCING
Organizations outsource when they decide to buy something they had been making inhouse previously. For example, a company whose employees clean the buildings may
decide to hire an outside janitorial firm to provide this service. That a huge wave of outsourcing and privatization (in the public sector) has hit almost all organizations during the
last decade is evident. In the urge to downsize, “right size,” and eliminate headquarters
staff, and to focus on value-added activities and core competencies in order to survive and
prosper, public and private organizations have outsourced an extremely broad range of
functions and activities formerly performed in-house. Some activities, such as janitorial,
food, and security services, have been outsourced for many years. Information Systems
(IS) is one activity that has received much attention recently as a target for outsourcing.
Other popular outsourcing targets are mail rooms, copy centers, and corporate travel
departments. Almost no function is immune to outsourcing. Accounts payable, human resources, marketing/sales, finance, administration, logistics, engineering, and even supply
are examples of functions now outsourced, but previously done in-house. An entire function may be outsourced, or some elements of an activity may be outsourced and some kept
in-house. For example, some of the elements of information technology may be strategic,
some may be critical, and some may lend themselves to lower cost purchase and management by a third party. Identifying a function as a potential outsourcing target, and then
breaking that function into its components, allows the decision makers to determine which
activities are strategic or critical and should remain in-house, and which can be outsourced.
The growth in outsourcing in the logistics area is attributed to transportation deregulation, the focus on core competencies, reductions in inventories, and enhanced logistics
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128 Purchasing and Supply Management
management computer programs. Lean inventories mean there is less room for error in
deliveries, especially if the organization is operating in a just-in-time mode. Trucking
companies have started adding the logistics aspect to their businesses—changing from
merely moving goods from point A to point B, to managing all or a part of all shipments
over a longer period of time, typically three years, and replacing the shipper’s employees
with their own. Logistics companies now have computer tracking technology that reduces
the risk in transportation and allows the logistics company to add more value to the firm
than it could if the function were performed in-house. Third-party logistics providers track
freight using electronic data interchange technology and a satellite system to tell customers
exactly where its drivers are and when the delivery will be made. In a just-in-time environment, where the delivery window may be only 30 minutes, such technology is critical.
For example, Hewlett-Packard turned over its inbound raw materials warehousing in
Vancouver, Washington, to Roadway Logistics. Roadway’s 140 employees operate the
warehouse 24 hours a day, seven days a week, coordinating the delivery of parts to the
warehouse and managing storage. Hewlett-Packard’s 250 employees were transferred to
other company activities. Hewlett-Packard reports savings of 10 percent in warehousing
operating costs.
The reasons for outsourcing are similar to those advanced for the buy option in make or
buy decisions earlier in this chapter. There is a key difference, however. Because the organization was previously involved in producing the product or service itself, the question
arises: “What happens to the employees and space and equipment previously dedicated to
this product or service now outsourced?”
Layoffs often result, and even in cases where the service provider (third party) hires
former employees, they are often hired back at lower wages with fewer benefits. Outsourcing is perceived by many unions as efforts to circumvent union contracts. The United Auto
Workers union has been particularly active in trying to prevent auto manufacturers from
outsourcing parts of their operations. Additional concerns over outsourcing include:
• Loss of control.
• Exposure to supplier risks: financial strength, loss of supplier commitment, slow implementation, promised features or services not available, lack of responsiveness, poor
daily quality.
• Unexpected fees or “extra use” charges.
• Difficulty in quantifying economics; conversion costs.
• Supply restraints.
• Attention required by senior management.
• Possibility of being tied to obsolete technology, and
• Concerns with long-term flexibility and meeting changing business requirements.
As organizations have gained more experience in making outsourcing decisions and
crafting outsourcing contracts, they have become better at applying sourcing and contracting
expertise to these decisions. From writing the statement of work or request for proposal to
defining the terms and conditions, the success of an outsourcing agreement lies in the details.
The two cases on outsourcing at the end of this chapter are illustrative of typical outsourcing decisions. B&L Inc. is considering the outsourcing of a part currently produced
in-house. Rondot Automotive deals with the outsourcing of a whole process, in this case,
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Make or Buy, Insourcing, and Outsourcing 129
painting. Both are useful examples of the processes followed by supply managers in analyzing outsourcing decisions.
OUTSOURCING SUPPLY AND LOGISTICS
In a CAPS study on outsourcing, it was found that there was little outsourcing of typical
supply management activities. The activities most likely to be outsourced were inventory
monitoring, order placement, and order receiving, with more than 40 percent of respondents expecting increased outsourcing in inventory monitoring and order placement.
Many tasks associated with the logistics function as well as the entire function itself
have been heavily outsourced. The tasks typically outsourced include freight auditing,
leasing, maintenance and repair, freight brokering, and consulting and training.
Deciding what represents a core competency to an organization is not always an easy
task, nor is the decision always the same for a specific function. For example, ownership
and management of an in-house fleet of vehicles may be subject to the decision to outsource or maintain in-house. In an organization where the sales force is large, the cars for
sales representatives may be seen as an extension of the sales force, and part and parcel
of the company’s ability to outperform the competition in personal sales. Many of the
functions of fleet may be outsourced—leasing rather than owning vehicles, maintenance,
resale of vehicles—but the contact with the drivers may be retained as an in-house function
because keeping the drivers (sales force) happy is critical to the success of the organization. In a utility company, the mechanical expertise needed to maintain specialty vehicles
may be seen as part of the company’s core competency, whereas the maintenance of the
automobile fleet may not. The outsourcing decision is a function of many factors, and each
organization must assess these factors based on the goals and objectives and long-term
strategy of the organization.
SUPPLY’S ROLE IN INSOURCING AND OUTSOURCING
Research indicates that supply has had relatively moderate involvement in the outsourcing
decisions made in many organizations. However, given the nature of these insourcing and
outsourcing decisions, supply managers should be heavily involved to add in the following
ways:
•
•
•
•
•
•
Providing a comprehensive, competitive process.
Identifying opportunities for insourcing or outsourcing.
Aiding in selection of sources.
Identifying potential relationship issues.
Developing and negotiating the contract.
Ongoing monitoring and management of the relationship.
The strategic importance of make or buy, insourcing, and outsourcing decisions is so
high that great care needs to be exercised to make sure these decisions are right. Obviously,
appropriate supply input is critical for these decisions as well as supply management subsequently to assure the success of whichever option has been chosen.
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130 Purchasing and Supply Management
Conclusion
Make or buy, insourcing, and outsourcing are key strategic decisions for any organization.
That each of these decisions can be reviewed and reversed at a later date, as conditions
warrant, adds to the challenge of maintaining an appropriate mix of in-house activities and
purchased goods and services. Obviously, effective supply management requires an ongoing active contribution from supply into this continuing assessment process. The more
skilled the supply group at exploiting market opportunities and developing competitive
sources, the more ready the organization should be to buy outside and outsource.
Questions
for
Review
and
Discussion
1. Why should an organization switch from making to buying?
2. What is outsourcing? How might one make the decision to outsource an activity
or not?
3. Why is the make or buy decision considered strategic?
4. What is the gray zone in make or buy? What are its implications?
5. Why might an organization decide to insource? Can you give an example?
6. What is subcontracting?
7. Why would an organization outsource its logistics? Engineering? Marketing?
8. In the public sector what name is frequently used for outsourcing? What are some
major impediments to outsourcing in the public sector?
9. What role is expected of supply once an insourcing decision has been made?
10. If you were the sole owner of your own company, would you favor the make side or
the buy side of the make or buy decision? Why?
References
Carter, Joseph R.; William J. Markham; and Robert M. Monczka. “Procurement
Outsourcing: Right for You?” Supply Chain Management Review 11, no. 4, May–June
2007, p. 26.
Gilley, K. M., and A. Rasheed. “Making More of Doing Less: An Analysis of Outsourcing
and Its Effect on Firm Performance.” Journal of Management 26, no. 4 (2000),
pp. 763–790.
Halvey, John K., and Barbara Murphy Melby. Business Process Outsourcing: Process,
Strategies and Contracts. 2nd. ed. Hoboken, NJ: John Wiley & Sons, 2007.
Hayes, R. H; G. P. Pisano; D. M. Upton; and S. C. Wheelwright. Operations Strategy and
Technology: Pursuing the Competitive Edge. New York: Wiley, 2005.
Mol, Michael J. Outsourcing, Supplier Relations and Internationalisation: Global
Sourcing Strategy as a Chinese Puzzle. Rotterdam, The Netherlands: Ersamus Research
Institute of Management (ERIM), 2001.
Parker, David W., and Katie A. Russell. “Outsourcing and Inter/Intra Supply Chain
Dynamics: Strategic Management Issues.” Journal of Supply Chain Management 40,
no. 4, Fall 2004, p. 56.
Takeishi, A. “Bridging Inter- and Intra-firm Boundaries: Management of Supplier
Involvement in Automobile Product Development. Strategic Management Journal 22,
no. 5 (2001), pp. 403–433.
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Make or Buy, Insourcing, and Outsourcing
131
Tompkins, James A.; Steven W. Simonson; Bruce W. Tompkins; and Brian E. Upchurch.
“Creating an Outsourcing Relationship: Successful Outsourcing Depends as Much
on the Kind of Relationship Developed as It Does on the Details of the Operational
Execution.” Supply Chain Management Review 10, no. 2, March 2006, p. 52.
Case 5–1
B&L Inc.
Brian Wilson, materials manager at B&L Inc. in Lancaster,
Pennsylvania, was considering a proposal from his purchasing agent to outsource manufacturing for an outrigger
bracket. It was the end of April and Mr. Wilson had to evaluate the proposal and make a decision regarding whether
to proceed.
Manufacturing lead time for the outrigger bracket was
two weeks. However, the Metal Fabricating Division had
been able to coordinate supply and production with assembly operations. Consequently, finished inventory levels of
the outrigger bracket were kept to a minimum. B&L’s inventory holding costs were 20 percent per annum.
B&L INC. BACKGROUND
THE OUTSOURCING DECISION
B&L Inc. manufactured trailers for highway transport
trucks. The company comprised three divisions: the Trailer,
Sandblast & Paint, and Metal Fabricating Divisions. Each
division operated as a separate profit center, but manufacturing operations between each were highly integrated. The Metal Fabricating Division produced most of
the component parts of the trailers, the Trailer Division
performed the assembly operations, and the Sandblast &
Paint Division was responsible for completing the sandblasting and final painting operation. B&L manufactured
approximately 40 trailers per year, with about two-thirds
produced during the period from November to April.
In an effort to reduce costs, the purchasing agent, Alison
Beals, who reported to Brian Wilson, solicited quotes
from three local companies to supply the outrigger bracket.
Mayes Steel Fabricators (Mayes), a current supplier to
B&L for other components, offered the lowest bid, with a
cost of $108.20, FOB B&L.
Brian met with the controller, Mike Carr, who provided a breakdown of the manufacturing costs for the
outrigger bracket. Looking at the spreadsheet, Mike commented: “These are based on estimates of our costs from
this year’s budget. Looking at the material, labor, and
overhead costs, I would estimate that the fixed costs for
this part are in the area of about 20 percent. Keep in mind
that it costs us about $75 to place an order with our vendors.” Exhibit 1 provides B&L’s internal cost breakdown
and details from the quote from Mayes.
THE OUTRIGGER BRACKET
The outrigger bracket, part number T-178, was an accessory that could be used to secure oversized containers.
The bracket consisted of four component parts welded
together, and each trailer sold by B&L had 20 brackets—
10 per side.
The Metal Fabricating Division was presently manufacturing the outrigger bracket. The subassembly parts—
T-67, T-75, T-69, and T-77—were processed on a burn
table, which cut the raw material to size. Although the
burn table could work with eight stations, this machine
had only been operating with one station. The final assembly operation, T-70, was performed at a manual welding
station.
joh77899_ch05_120-134.indd 131
EXHIBIT 1 Manufacturing Costs and Mayes
Quote: Outrigger Bracket T-178
Parts
T-67
T-75
T-69
T-77
T-70
Total
Mayes Steel
Fabricators
B&L Manufacturing
Costs
$14.60
21.10
18.50
13.00
41.00
$108.20
$17.92
17.92
45.20
10.37
58.69
$150.10
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132 Purchasing and Supply Management
Brian expected that B&L would have to arrange for
extra storage space if he decided to outsource the outrigger bracket to Mayes, who had quoted delivery lead time
of four weeks. Because Mayes was local and had a good
track record, Brian didn’t expect the need to carry much
safety stock, but the order quantity issue still needed to
be resolved.
B&L was operating in a competitive environment and
Brian had been asked by the division general manager to
look for opportunities to reduce costs. As he sat down to
review the information, Brian knew that he should make
a decision quickly if it was possible to cut costs by outsourcing the outrigger bracket.
Case 5–2
Rondot Automotive
It was September 28 and Glenn Northcott, purchasing
planner at Rondot Automotive in Jackson, Mississippi,
was evaluating an important outsourcing opportunity. For
the past three months, Glenn had been working on a project that involved evaluating the feasibility of outsourcing
the plant’s painting requirements, and he had just finished
collecting much of the necessary technical and cost information. Glenn had to complete his evaluation in advance
of a meeting scheduled with his boss, Terry Gibson, purchasing manager, and the plant manager, Dick Taylor, in
one week’s time to discuss this matter and to decide what
action, if any, needed to be taken next.
RONDOT WORLDWIDE
Rondot Automotive was a wholly owned subsidiary of
Rondot Worldwide, a leading global designer and manufacturer of electrical and electronic components. Rondot
Worldwide operated in more than 100 countries, employing more than 200,000 people. It was a key player in the
information and communications, automation and control,
power, transportation, medical, and lighting industries.
Rondot Automotive operated 85 plants in 25 countries.
It was known for providing high-quality, innovative products in automotive electronics, electrics, and mechatronics. The Jackson, Mississippi, plant manufactured small
motors for a number of applications, including engine
cooling, HVAC (heating, ventilation, and cooling), and
antilock brake systems. The plant produced approximately
7 million motors per year, which were shipped directly to
OEM assembly facilities for customers such as Ford, GM,
DaimlerChrysler, Honda, Toyota, and BMW.
Rondot Automotive was facing considerable global
competition and significant pressures from its customers
for price reductions. As a result, total sales and employment at the Jackson plant had steadily declined over the
past five years. The number of employees at the plant had
joh77899_ch05_120-134.indd 132
dropped from 1,450 to 600, and plant management was
under pressure to lower costs and regain market share.
The purchasing organization at Rondot Automotive
was a hybrid structure. The corporate strategic purchasing group operated from the company’s head office in
Troy, Michigan, and was responsible for negotiating major contracts with suppliers and working on new product
development initiatives. Plant-level purchasing organizations reported to the plant managers on a solid-line basis
and corporate purchasing on a dotted-line basis. Plant
purchasing managers were responsible for materials management, negotiating contracts for local requirements and
small-value purchases. The purchasing department at the
Jackson plant consisted of four people, including two buyers, a planner (Glenn), and Terry Gibson. Glenn had joined
Rondot right out of college the previous year.
OUTSOURCING OPPORTUNITY
A steel housing was manufactured for each of the six
different families of motors manufactured at the Jackson
plant. The housings were “deep drawn” in large stamping presses in a batch operation. Following stamping, the
housings were processed through a zinc phosphate treatment for cleaning and then painted. Quality specifications stipulated that the coating on the housing had to be
capable of withstanding 240 hours of salt spray testing.
The cleaning and painting process involved a
continuous-flow wet paint system that had been installed
in a 20,000-square-foot section of the plant approximately
17 years prior. The system had undergone a number of upgrades and modifications, in part to comply with evolving
environmental regulations.
Based on data from the plant controller, Ken Lee, Glenn
had learned that the cleaning and painting operations cost
25¢ for each housing. Ken commented to Glenn: “We
estimate our costs to include 10¢ in material, 3¢ in labor,
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Chapter 5
and the rest in overhead, including expenses such as taxes,
energy, maintenance, and charges from corporate office.”
GREVEN E-COATING
Glenn had been approached by an enterprising local vendor several months back, inquiring about Rondot’s painting requirements. Cathy Stirling, representing Greven
E-Coating Company (Greven) proposed that she prepare
samples for each family of housings and provide cost estimates to Glenn. Eager to explore cost savings opportunities, Glenn readily agreed.
Electrocoating, or e-coating, uses a system whereby a
DC electrical charge is applied to a metal part immersed
in a bath of oppositely charged paint particles. The metal
part attracts the paint particles, forming an even film over
the entire surface, until the coating reaches the desired
thickness. E-coating was generally considered more cost
efficient compared to traditional wet paint systems.
Samples from Greven were sent to Rondot’s quality
control department for testing and the results seemed
encouraging. The tests indicated that parts for five of
the six families of housings, representing approximately
60 percent of the Jackson plant’s housing volume, could
be converted to e-coating using Greven at a cost of 15¢
each. One family of housings failed the tests because of
problems with the method of adhering a magnet to the
housing. Rondot’s assembly process required a magnet
to be attached to the top inner portion of each housing
using either a cold or hot bonding adhesion process. The
use of either method was dependent on product design,
Make or Buy, Insourcing, and Outsourcing 133
and engineering specified the adhesion method used. The
one family of housings that used a cold-bond adhesion
process had failed the test, while the other five families, which used a hot-bond process, passed the testing
process.
As part of the data-gathering process for this project,
Glenn also talked to Betty McKinley, from production
planning, and John Underwood, in manufacturing engineering. Betty figured that she would need to add another
two weeks’ worth of inventory if painting operations were
to be outsourced. She reminded Glenn to expect to pay
3¢ per part for transportation and packaging.
John was delighted at the prospects of eliminating the
paint line, indicating: “In the not-too-distant future, we are
going to have to spend some money to upgrade our system or pull the line out completely. These old wet-based
systems are less efficient compared to other technologies
available today, in terms of both cost and environmental
performance.”
PREPARING FOR THE MEETING
Glenn was aware that Terry Gibson and Dick Taylor were
under significant pressure to reduce costs at the Jackson
plant and he felt that outsourcing painting operations represented a good opportunity. However, this was his first
major project and Glenn wanted to make sure that he had
taken all the necessary issues into account and developed
a strong case for his recommendations before his meeting
the following week.
Case 5–3
Alicia Wong
Alicia Wong, Corporate Supply Manager, Thain Foods
Limited, wanted to prepare a proposal to manufacture
mustard in-house. Mustard, an important ingredient in
many of the company’s products, was currently purchased
from an outside supplier. She hoped a comprehensive
proposal could be prepared in one-month’s time for the
CEO’s approval.
GENERAL COMPANY BACKGROUND
Thain Foods Limited (TFL) had been in business for
more than 30 years. Its products included a wide range of
syrups, fudges, cone dips, sauces, mayonnaise, and salad
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dressings. Its customers were major food chains, hotels,
and restaurants in North America and Europe.
TFL believed in continuous improvement to its
operations. Over the last two years, it invested more than
$2 million in plant facilities, the bulk of it new, state-ofthe-art process equipment and process control. All production and process control functions were computerized
for maximum efficiency.
TFL employed about 120 people. It had a corporate
structure of CEO; president; executive vice president,
domestic sales; and national account manager and used
a network of food brokers who sold and promoted its
products.
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134 Purchasing and Supply Management
THE SUPPLY AREA
Alicia was responsible for supply and reported directly to
the CEO. She had an inventory control officer, a buyer and
a receiver under her supervision. Purchases could be classified into five different types: labels, packaging, raw materials, commodities and MRO supplies. Mustard was an
important raw material used in many of TFL’s products.
CURRENT PRACTICE: PURCHASING
MUSTARD EXTERNALLY
Whenever mustard was required, the buyer e-mailed the
supplier and requested that it prepare the appropriate
amount to be picked up by a truck from TFL. The purchase order would be prepared before the truck left for
the supplier, normally the next day. The mustard supplier
used mustard seed as its raw material and blended in the
other ingredients after the seed had been reduced to mustard flour. Every month TFL purchased 500 drums, or
100,000 liters, of mustard. The cost of the mustard itself
was $64 per drum. Freight costs were borne by TFL and
amounted to about $8 per drum. TFL operated three eighthour shifts, five days a week. Each worker was paid about
$20 per hour. It took about 10 minutes of a worker’s time
to handle each drum. This included pouring the mustard
into the processing kettle, making sure other added ingredients mixed well, and rinsing the drums. The drums were
bulky and because they could not be used in the plant for
other purposes, had to be rinsed for a contractor who took
them away. The costs of disposing of the drums in this
manner were negligible. Other costs and overhead of purchasing were $0.02 per liter.
SUGGESTED CHANGE:
MANUFACTURING MUSTARD
IN-HOUSE
The mustard to be produced at TFL would be composed
of roughly 60 percent solid, 20 percent water, and 20 percent
joh77899_ch05_120-134.indd 134
vinegar. The solid portion was a spice blend, consisting essentially of mustard flour, salt, and other spices that could
be readily bought. Water was not a problem because the
city provided a reliable supply. Vinegar was already a raw
material that TFL ordered in bulk regularly from suppliers. Alicia therefore believed that it was a simple matter
for TFL to make the mustard for its own use. TFL only
needed to buy the spice blend and add water and vinegar
in the right proportions. She approached a supplier who
indicated that it could make the spice blend at a delivered
price of $0.15 per liter for TFL, including freight. However,
it needed time for tests to ensure that the blend would
be of the right quality for TFL’s use. Vinegar cost TFL
$0.1875 per liter delivered in 15,000 liter lots. And TFL
was paying $0.025 per liter for water. Alicia also checked
whether production had the time and equipment to make
the mustard. Production felt that the change would not be
too drastic and no additional workers would be necessary.
However, it would use up more of the existing workers’
time. Production calculated that the change would entail a
total labor and overhead cost of about $0.105 per liter of
mustard using standard cost accounting for labor time and
overhead charges.
Alicia organized an information gathering and discussion session involving supply, production, quality assurance, and distribution to discuss the proposed change.
The workers were keen on the idea because this meant
that they would no longer have to haul and rinse the
bulky drums (water and vinegar could be easily channeled to the mixing containers using existing pipes).
However, quality assurance expressed concern about
the quality of mustard if produced in-house. Because the
mustard was an ingredient in many of TLF’s products,
such a change might adversely affect the quality and
taste of these products.
Alicia wanted her proposal for in-house manufacture
of mustard to be in the company’s best interest and wondered how to proceed next.
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Chapter Six
Need Identification
and Specification
Chapter Outline
Need Criteria in the Value Proposition
1. Strategic Criteria
2. Traditional Criteria
3. Additional Current Criteria
Categories of Needs
1. Resale
2. Raw and Semiprocessed Materials
3. Parts, Components, and Packaging
4. Maintenance, Repair, and Operating
Supplies
5. Capital
6. Services
7. Other
Repetitive or Nonrepetitive
Requirements?
Early Supply and Supplier Involvement
Methods of Description
Brand
“Or Equal”
Specification
Miscellaneous Methods of Description
Combination of Descriptive Methods
Sources of Specification Data
Standardization and Simplification
Conclusion
Questions for Review and Discussion
References
Cases
6–1 Moren Corporation (A)
6–2 Moren Corporation (B)
6–3 Carson Manor
Commercial Equivalents
135
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136 Purchasing and Supply Management
Key Questions for the Supply Decision Maker
Should we
• Rethink our approach to strategic requirements?
• Initiate a simplification and standardization program?
• Change our specification method?
How can we
• Define our internal needs better to suppliers?
• Improve our acquisition of services?
• Leverage our environmental successes in the supply chain?
Two key decisions are addressed in this chapter: (1) How do we determine organizational
needs? and (2) How do we translate and communicate these needs to (potential) suppliers?
Since need identification and specification are major value influencers, these questions
deserve special attention.
Organizational needs that must be met by outside suppliers arise in every part of the
organization and with every employee. Furthermore, if the organization serves a customer
base with goods and/or services, these customer needs could well be the main drivers of
the acquisition system of the organization. Therefore, for an automobile manufacturer,
by far the largest portion of its spend with suppliers (for Toyota close to 80 percent of its
total costs) is spent on automobile materials and parts that will comprise the vehicle sold
to customers. A good place to start addressing the need questions is to identify the major
influencers of those needs. Need identification depends on the nature, size, and location of
the organization as described in the first chapter. In this chapter the category of need will
be addressed as well as description of needs.
NEED CRITERIA IN THE VALUE PROPOSITION
The management of supply is keenly concerned about the value proposition for specific needs
acquired from suppliers. The criteria for deciding what, in a particular instance, represents
good value fall into three levels: (1) strategic, (2) traditional, and (3) additional current.
The Moren Corporation (A) case at the end of this chapter is a good example of the application of the three levels of criteria to the service acquisition on a major capital project.
What criteria should apply to the design of a project, and what are the implications of purchasing the design from an outside firm?
1. Strategic Criteria
The overreaching question concerning any organizational requirement deals with the strategic impact. Is this a strategic requirement or not?
One potential and frequently used attribute is the financial implication or impact of the
requirement. A breakdown of any organization’s acquisition needs according to an ABC
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Chapter 6 Need Identification and Specification
137
analysis in which about 10 percent of the number of separate needs account for 70 percent to
80 percent of the dollar value of the total corporate spend, identifies the major spend areas.
Focusing significant management attention on these high spend needs makes a lot of sense.
Strategic sourcing is often used for this category aligning supply strategy to corporate strategy.
Aside from the amount spent, there are other criteria for making a requirement strategic.
They may involve risk reduction, access to new technology or new markets, assurance of supply in tight markets, revenue enhancement, potential competitive benefits, corporate image
or reputation improvement and others. These other criteria may be less obvious and require
the supply manager to think strategically at a corporate level rather than on an operational
and process-focused level. Creativity and a focus on the future are also required to identify
which needs are strategic and which ones are not. Unfortunately, corporate requirements do
not reach the supply manager with labels attached: strategic or not strategic. Thus, a major
contribution opportunity for the supply manager is to bring to light strategic implications of
certain requirements, given specific market conditions and corporate strategic aspirations.
The identification of a requirement as strategic demands a very high degree of subsequent supply attention.
2. Traditional Criteria
Traditional criteria for supply management comprise the traditional value proposition of
(1) quality, (2) quantity, (3) delivery, (4) price and (5) service.
1. Quality: Quality as a term covers both functionality: “Does it do the job we want
done?” and conformance to specification: “Does it fit the specification agreed to?”
Failure to meet quality criteria makes the product or service unacceptable, with potentially serious consequences for the supply organization and its customers. Therefore,
meeting quality standards is a first and minimum demand on suppliers.
2. Quantity: The quantity supplied has to be sufficient to meet demand.
3. Delivery: The timing of the delivery has to meet the purchasing company’s needs. This
can be fast or slow, but must be as promised.
4. Price: On the assumption that the previous three criteria of quality, quantity, and delivery are up-front requirements that must be met, or order qualifiers, then price can
be used as the “order getter.” The distinguishing difference may be the price and terms
offered by different suppliers. The four criteria of quality, quantity, delivery, and price
are covered in significant detail in the following four chapters. Therefore, their treatment in this chapter is short.
5. Service: Service may include design, recordkeeping, transportation, storage, disposal,
installation, training, inspection, repair, and advice, as well as a willingness to make
satisfactory adjustments for misunderstandings or clerical errors. Some supply managers
include the supplier’s willingness to change orders on short notice and be particularly responsive to unusual requests as part of their evaluation of the service provided. To cover
some types of service, suppliers issue guarantees, covering periods of varying length.
If the service is vital to the success of the purchase, such as installation for equipment,
or training of operators, then it needs to be specified as part of the requirement. Service
components like a helpful and pleasant attitude, though real, may be more difficult to quantify, yet distinguish one supplier from another.
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138 Purchasing and Supply Management
Many suppliers specifically include the cost of service in the selling price. Others absorb
it themselves, charging no more than competitors and relying on the superior service for
the sale. One of the difficult tasks of a purchaser is to get only as much of this service factor as is really needed without paying for the excessive service the supplier may be obliged
to render to some other purchaser. In many instances, of course, the service department of
a manufacturing concern is maintained as a separate organization and profit center. Obviously, the availability of service is an important consideration for the buyer in securing the
“best buy” at the outset.
Although in practice many purchasers refer to a supplier as providing good service
when the supplier delivers regularly on time, that is not the correct definition of service.
Some service factors may only come to light after a trade relationship has been established.
The reason these five criteria—quality, quantity, delivery, price, and service—have
been labeled traditional is that they have been identified in supply literature for more than
100 years. They make common sense, are largely quantifiable, and make up a very large
percentage of most existing supplier evaluation systems.
The Moren Corporation (B) case at the end of this chapter requires special consideration
of the traditional five criteria as they apply on a major construction project.
3. Additional Current Criteria
Supply management has become more complicated over the past decades. Additional criteria have been added beyond strategic and traditional, thereby increasing the difficulty of
assuring a sound value proposition.
These additional current criteria include: financial, risk, environmental impact, innovation, regulatory compliance, and social and political factors.
1. Financial
Financial criteria beyond price include improvement of the corporate financial statements,
both balance sheet and income statement, to raise the company’s attractiveness in the eyes
of the investment community. They include revenue enhancement, working capital and
accounts receivable reduction, cash flow improvement, inventory reduction, and any other
initiative that improves return on assets or investment, raises the share price, or lifts the
company’s financial ratings.
2. Risk
Every business decision involves risk, and supply is no exception. Supply chain risk can
be classified into three main categories: (1) operational risk: in supply terms, the risk of
interruption of the flow of goods or services, (2) financial risk: in supply terms, the risk that
the price of the goods or services acquired will change significantly, and (3) reputational
risk: in supply terms, risk that the reputation of the enterprise is adversely affected by the
method of acquisition or the behavior of the supplier. All three risks affect the survival,
competitiveness, and bottom line of the organization and may occur simultaneously. Chapter 2 provides more detail on managing supply risks.
3. Environmental
Climate change and water, earth, and air pollution have raised environmental concerns that
must be addressed in all areas of the supply chain. While disposal of hazardous goods has
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Chapter 6 Need Identification and Specification
139
been a responsibility of supply managers for several decades, environmental issues have
grown considerably. Reexamining the total supply chain from an environment perspective
raises questions way beyond hazardous goods disposal. The amount of energy and water and
scarce resources used, the transportation and handling systems and distances traveled, the discharge of undesirable gases into the air or substances into the earth—all influence the design,
movement, creation, and disposal phases in the supply chain to minimize the “footprint.”
Thus, the “best buy” has to include environmental impact as a standard consideration.
4. Innovation
Innovation as a criterion for determining best value refers to the pursuit of continuing improvement. Current suppliers are expected to provide suggestions for value improvement
and total cost of ownership reduction on an ongoing basis. Such suggestions may require
the supply organization to make changes in design, communication, handling, advance notice, scheduling, or any other supply chain practice that can be improved. Innovation suggestions may also involve supplier changes and any other suggestions that may improve
the purchaser’s revenues or costs. The reason for including innovation as an additional
value criterion is that the supplier is forced to ask, How can we do better? and What can
make my customer more successful?
5. Regulatory Compliance and Transparency
All agreements reached between buyers and sellers have to comply with the relevant laws
and regulations.
Failure to comply can damage the reputation of the parties and result in fines or citations. The legal framework for trade is covered later in this text. Suffice it to say here that
an extensive and growing legal and regulatory structure affects trade in most developed
countries, and compliance is not a minor matter. Moreover, financial scandals and new accounting standards have increased demands for greater transparency on all financial dealings of a company. Therefore, long-term contracts, lease obligations, and hedge positions
have to be reported properly. Failure to do so may mislead investors and incur the wrath
and penalties of a range of industry watchdogs and regulators.
6. Social and Political Factors
Corporate social responsibility (CSR) has become prominent in the last decade. Companies
are supposed to behave like good corporate citizens and recognize that they have social responsibilities in the countries in which they operate. Therefore, dealing with socially responsible suppliers is a plus for the supply organization’s image. Promoting opportunities for
disadvantaged, minority, and small business suppliers to quote and receive corporate orders
is seen as a socially desirable action. MRO and small value purchasers are typical categories
of needs wherein socially disadvantaged and small suppliers can make a reasonable value
proposition. Activists often link environmental and social sensitivity together as one area
where organizations must demonstrate a willingness to search for better solutions. Building
an environmentally advanced facility in a high unemployment area of the country would be
seen as a concrete example.
Political concerns do not refer to paying politicians under the table. They include a
willingness to support the government in its priorities, rather than opposing them. If it is
possible to support “Buy Local” government initiatives, then a company is expected to do
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140 Purchasing and Supply Management
so, even if it is not a hard regulatory requirement. Assisting government training initiatives
and working on government-sponsored industry panels would be additional examples.
The collective set of strategic, traditional, and additional current criteria for need identification and subsequent supply chain decisions makes for a complex analysis in which
judgment also plays an important part. Not every acquisition will require an exhaustive analytical review, but the supply professional through experience and judgment learns which
criteria are likely to be relevant for any particular acquisition.
The Carson Manor case at the end of this chapter deals with the challenge of evaluating
service supplier bids in response to a request for proposals based on a fairly broad definition of needs. How do you know that one consultant fits your needs better than another?
CATEGORIES OF NEEDS
Organizational needs can be classified broadly into seven categories. These are (1) resale,
(2) raw or semiprocessed materials, (3) parts, components, and packaging, (4) maintenance, repairs, and operating suppliers (MRO), (5) capital, (6) services, and (7) other. Each
of these categories covers a very wide range of requirements (see Table 6–1).
TABLE 6–1
Categories of
Needs
Categories of Needs
1. Resale
2. Raw and
Semiprocessed
Materials
3. Parts, Components,
and Packaging
4. Maintenance,
Repair, and Operating Suppliers (MRO)
and Small Value
Purchases (SVP)
5. Capital
6. Services
7. Other
joh77899_ch06_135-164.indd 140
Resellers comprise retailers, wholesalers, distributors, agents,
brokers, and traders. What they can resell covers the full
range of the remaining five categories below.
Most users of materials are converters, such as factories,
and this category includes commodities, agricultural, and
industrial.
Assemblers use parts and components produced by their
suppliers to create a finished product. Parts and components
may be standard or special depending on the decision of the
designer of the finished product.
Every organization has MRO requirements and SVPs. The
availability of MRO suppliers is critical to maintain continued
uninterrupted operation of the office, factory, facility, etc.
Because many MRO requirements are relatively small in dollar
value, SVPs are also included in this category. For SVPs, assuring availability at minimum acquisition cost is a challenge.
Any requirement that accountants classify as capital, and,
therefore, an investment, becomes a capital item. Equipment,
IT, real estate, and construction are included in this category.
Capital items can be depreciated, are often bought under
a separate budgetary allocation, and may require special
financing arrangements.
Every organization acquires a variety of services.
Anything not covered by the above categories falls into this last
one. Major requirements could be energy and water. This category would also include unusual and infrequent requirements,
probably better dealt with on an ad hoc or project basis.
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Chapter 6 Need Identification and Specification
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In large organizations it is usual to assign supply professionals all or part of a category
of requirements. In small organizations one person may have to cover the full range. The
supply execution required for each category may be different, as discussed below.
1. Resale
Since resellers represent a distribution channel between buyers and sellers, the abilities to
buy well and sell profitably are critical to success. Resellers, who do not take possession of
goods or supply additional services, may charge a small margin. The potential for a reseller’s customer to bypass the reseller and deal directly with the reseller’s supplier is an everpresent threat, as is the possibility that the reseller’s supplier will bypass the reseller and deal
directly with the reseller’s customers. For example, Honda recently decided to discontinue
selling its nonautomotive products such as ATVs and motorbikes through separate dealers
and to consolidate all Honda brand products with automotive dealerships. Insurance companies often sell their products and services through brokers as well as their own sales force.
Airlines sell direct to customers as well as through travel agents. By definition, the largest
single cost for a reseller who takes ownership of the goods it resells is what it paid for the
goods or services. Therefore, financial management of receivables and payables and cash
flow is a major skill required most along with logistics management. Walmart is reputed to
be able to sell a very large portion of its store merchandise before it has to pay its suppliers.
In effect, its suppliers are financing Walmart’s operations and inventories.
Manufacturers may choose to resell some products to complete a full line, may offer
maintenance, lubricants, or parts to improve the attractiveness of their products in use.
In the fashion industry, the ability of the retail buyer to spot trends and assess the likelihood that a given style or color of garment will sell well is a critical attribute.
2. Raw and Semiprocessed Materials
A steelmaker needs iron ore or scrap steel, coke, and a range of additives to create finished steel
with particular properties. Commodities in the agricultural world are subject to availability and
price fluctuations. Industrial commodities also experience supply and demand effects on price.
Commodities that are traded on exchanges show daily price variations, and buyers need to
decide whether to buy forward or hand to mouth as well as decide on hedging strategies.
The purchases of large commodity buyers, such as Nestle for coffee and cocoa and Coca
Cola for sugar, will affect market prices. Commodity supply managers need to be fully
aware of market conditions. Supply and demand and price movements and proper timing
of acquisition commitments are critical. Semiprocessed materials—steel sheets instead of
ingots, frozen pork bellies instead of hogs, cocoa butter instead of beans—tend to move in
price as the basic raw material moves with a producer’s margin added.
Frequently labeled converters, suppliers of semiprocessed materials often are much
smaller companies than the providers of their raw materials, and may find themselves
squeezed between their suppliers and customers, each of which is trying to off-load the risk
of unfavorable price movement.
3. Parts, Components, and Packaging
It is unusual for an assembler to make all of its products’ parts and components itself.
Therefore, depending on suppliers to provide the necessary parts, components, and packaging is common. Design engineers and design experts determine what parts and components
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142 Purchasing and Supply Management
to buy and which to make in-house. They also decide whether to design standard parts
and components into the product or to specify custom design. The advantage of standard
parts and components is their ready availability. The disadvantage is the ease of copying. Motorola for many years had a very high percentage of custom-designed electrical
and electronic components in the product line. While affording duplication protection, this
practice also delayed new product introduction and increased component costs. Therefore,
a major initiative was undertaken to get engineers to design out of suppliers’ catalogs.
Since product design is a major influencer of product cost and speed to market, early
supplier involvement (ESI) is a fruitful concern for this category.
Packaging is another specialized requirement, with major disposal, environmental, and
transportation implications. Since packaging is discarded by the purchaser, it has potential
environmental impact. Yet the package has to protect its contents as it finds its way from
product manufacturer to final user. Damage during transport is a cost few parties are willing to assume. For some consumer items, such as cosmetics, the package can be a significant sales influencer. For a number of items, the packaging may be worth more than its
contents: for example, beverage containers, including beer. For consumer items, marketers, packaging designers, and packaging engineers are concerned with the aesthetic, sales
appeal, labeling, regulatory, and safety aspects. Specialty packaging suppliers may for a
fee or as a free service offer advice on various packaging options. For nonconsumer goods,
the primary packaging concerns are likely to be cost, environmental impact, and adequate
contents protection given the types of handling and transportation modes the packaged
goods will experience.
4. Maintenance, Repair, and Operating Supplies
Every organization has MRO requirements. Even the one-person office needs paper, IT,
janitorial supplies, and so forth. For some companies MRO requirements are huge. Syncrude, the world’s largest oil sands operator, has over 150,000 SKUs in its MRO category.
For many organizations because of the diversity of the MRO category and the large number of relatively small requirements (C items), the challenge is keeping acquisition costs
down relative to the value of what is purchased. It doesn’t make sense to spend $500 acquiring one $3 item. Therefore, MRO acquisition deals with many small value purchases
(SVPs) and SVPs are linked with the MRO category. Typical supply solutions include
systems contracting wherein one supplier is chosen to provide a large variety of products—
for example, all office, plumbing or electrical supplies on a daily or twice weekly delivery
schedule. Designated employees will order their department’s needs electronically from a
catalog, and the supplier provides accounting with a bi-weekly detailed invoice providing
with specific account totals by department. Letting users order their own needs directly
saves time and acquisition cost. Acquisition expertise is required to identify the needs, to
select a supplier, to develop a contract, and to monitor performance.
The following two categories, capital and service, will be discussed in greater detail
here, because the previous four categories are covered further in the other chapters. Both
capital and service requirements present unique supply considerations.
5. Capital
Capital expenditures are the result of investment and strategic decisions as opposed to
expenses and are shown on the balance sheet as assets. Accountants create separate capital
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Chapter 6 Need Identification and Specification
143
budgets, calculate depreciation, and advise on tax implications of capital purchases. Capital equipment can be acquired new or used and may be purchased outright or leased. The
Roger Haskett case in Chapter 3 illustrates a supply decision involving a lease for capital
equipment and the pros and cons of leasing.
Capital assets are long-term assets that are not bought or sold in the regular course of
business, have an ongoing effect on the organization’s operations, have an expected use of
more than one year, involve large sums of money, and generally are depreciated. Assets
may be tangible or intangible. Historically, tangible assets (land, buildings, and equipment)
have been the primary focus of managerial attention because they were the key drivers of
wealth. Today, intangible assets (patents, copyrights, ideas, and knowledge) are important
generators of wealth. Intangibles assets are especially challenging because traditional accounting procedures do not include valuation methods for intangibles.
According to the U.S. Census Bureau, U.S. businesses typically invest between $1 and
$1.5 trillion annually in new and used capital goods. In a weak economy, businesses tend
to cut back on capital investments and in a strong economy capital expenditures flow again.
The impact of such behavior on the sustainability of the supplier is one area of concern
for supply managers when they evaluate suppliers. Too little investment or inconsistent
investment in capital assets may signify serious organizational problems that will affect the
supplier’s ability to deliver quality goods or services in the long term.
The Challenge of Procuring Capital Assets The acquisition of capital goods represents
a key strategic move for an organization that could affect its competitive advantage for
years to come. On the other hand, it could be a routine matter of no great consequence. In
capital intensive industries such as mining or airlines, the acquisition of capital goods represents one of the single largest purchase categories and one of the greatest opportunities
for supply to affect top-line (revenue) and bottom-line growth. The risks associated with
the acquisition of capital assets can be high. From the budgeting process to the design of
equipment or buildings, determination of location for real estate purchases, and decisions
about enterprisewide hardware and software, many factors play into the ultimate success or
failure of a capital project. Clearly defined supply objectives that are linked to, and aligned
with, organizational strategy and supported by robust supply processes are as important
to successful capital acquisition and management as they are to noncapital purchases. Because of the high dollar amount and the long-term consequences of many capital projects,
the application of tools and techniques such as enterprisewide spend analysis; standardization of equipment, including hardware and software; globalization of processes; and cost
visibility are important.
The strategy for a specific capital acquisition depends on a number of factors, including the frequency of the purchase, the projected total cost of ownership, the amount and
timing of cash flows, and the potential impact of the purchase on business operations.
For example, if assets are replaced at regular intervals, it makes sense to form a close
working relationship with the supplier and focus on continuous improvement. At the
U. S. Postal Service, for example, the mission of the organization is universal service at
a reasonable cost in a timely manner. To achieve this mission consistently, large volumes
of letters and packages must be sorted accurately and quickly. Therefore, sorting equipment is a strategic capital acquisition for the Postal Service. Because of design requirements and the desire for standardized equipment across the national organization, only
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144 Purchasing and Supply Management
a few suppliers are available. The category management team works closely with these
suppliers to develop the specification, manage the cost structure, and deliver equipment
in a shortened cycle time that delivers consistent quality, operating speed, and lowest
total cost of ownership.
For one-time or infrequent high-value purchases, total cost of ownership analysis of the
purchase and the total supply chain costs are appropriate. There are many costs beyond
purchase price that affect the true “cost to the organization” of any particular buy and
especially for capital assets. A generally accepted figure is that the purchase price makes
up from 30 percent to 50 percent of the total cost of ownership (TCO) of a capital purchase. Other factors, such as maintenance and repair costs, operating costs, downtime, and
yield play key roles. Supply personnel must acquire the skills and knowledge necessary
to develop total cost of ownership models that estimate and capture costs throughout the
supply chain.
New Technology—New Equipment Competitive advantage stems from product or service differentiation or low-cost production. New technology frequently permits an organization to gain competitive advantage on both grounds––different products and services
at significantly lower cost. New technology is, therefore, of significant strategic interest to
most organizations. And new technology almost always implies new equipment and new
processes. It is this strategic dimension of new equipment acquisition that has traditionally
been overlooked by supply. Intellectual property rights, speed of acquisition, installation
and debugging, continuing supplier support for operational performances and upgrades,
and development of the next generation of technological advances become prime matters
of corporate concern.
For example, in the semiconductor industry, capital equipment purchases normally represent the largest single percentage category of all purchase dollars. At Intel the goal is to
tie capital equipment purchasing and equipment service to performance-based contracting.
Thus, the supplier gets paid for uptime and quality output. The more the running time
exceeds agreed-to output goals, the greater the rewards for the supplier. Future plans are
driven by the need for continuous improvement in cost per wafer and number of wafers
per year per machine. Only a few key supplier partners are included in Intel’s longer-range
technology road maps planning process––looking five years out. Total cost of ownership,
not just the cost of the equipment itself, drives future technology decisions. Obviously,
the corporate team approach is required to manage this process and exceptionally capable
individuals need to represent supply on the corporate team.
Equipment purchases involve, in part, engineering and production considerations and,
in part, factors largely outside the scope of these functions. From the former standpoint,
there are eight commonly recognized reasons for purchase: (1) capacity, (2) economy in
operation and maintenance, (3) increased productivity, (4) better quality, (5) dependability
in use, (6) savings in time or labor costs, (7) durability, and (8) safety, pollution, and emergency protection. Beyond these engineering questions are those that only the marketing,
supply, or financial departments, or general management itself, can answer. Is this a key
strategic commitment? Are style changes or other modifications in the present product
essential or even desirable? Is the market static, contracting, or expanding? Does the company have the funds with which to buy the machine that theoretically is most desirable,
or is it necessary, for financial reasons, to be satisfied with something that is perhaps less
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efficient but of a lower initial cost? What should be done in a case in which the particular equipment most desirable from an engineering standpoint is obtainable only from a
manufacturer that is not thoroughly trustworthy or perhaps is on the verge of bankruptcy?
Should we be the first or the last purchaser of this equipment? Such questions are quite as
important in the final decision as are the more purely engineering ones. For this reason it
is sound practice to form a cross-functional sourcing team including representatives from
engineering, using departments, finance, marketing, and supply to work jointly on major
equipment acquisitions.
Financing capital purchases requires special attention. For some organizations capital
purchases are routine; for example, a rapidly growing fast-food chain may start up and
equip hundreds of store locations per year. A major nuclear power plant, on the other hand,
may take a decade to plan and build and cost billions. Companies with large fleets of cars
may turn over one-third of the fleet each year and have a fleet manager assigned to decide
which vehicles to acquire, how to dispose of vehicles, and select insurance and maintenance
providers.
Nonroutine equipment acquisition may require a cross-functional project team representing users, marketers, designers, financial experts, and supply experts. If appropriate
expertise is lacking internally, outside consultants may be brought in.
6. Services
A 2003 CAPS benchmarking report, Managing Your Services Spend in Today’s Economy,
reported the breakdown of spend for participating companies as, on average, 44 percent
for direct spend, 23 percent for indirect, and 30 percent for services. If the economy
were broken into three segments: manufacturing, service, and public, then manufacturing organizations have a higher percent of spend allocated to the purchase of goods than
services, and public/governmental and service organizations have a much higher percent
allocated to services than goods. Service organizations have the highest percent of spend
for services.
The magnitude of the dollars spent to acquire services indicates that a professional supply department that attained a reduction of even 5 percent in overall prices paid would have
a major impact on an organization’s profitability. If the focus were placed on lowering total
cost of ownership, the contribution from a structured sourcing process and knowledgeable
supply managers would be even greater.
What Makes Services Different? One of the most commonly mentioned special attributes of services deals with the inability to store services because many services are processes (which may or may not be associated with a product). This implies that timing of the
delivery has to coincide with the purchaser’s specific delivery needs, and the consequences
of improper timing may be serious and costly. Service suppliers, trying to accommodate a
variety of customers, need to ensure that sufficient capacity is available to satisfy the needs
of all. The inability to store services also creates quality assurance difficulties. It may not
be possible to inspect a service before its delivery. And, by the time of delivery, it may be
too late to do anything about it. Anyone who has ever suffered through a boring speaker or
a bad airline flight will attest to that.
The specification and measurement of quality in a service may present significant
difficulties. Frequently, services have both tangible and intangible components. In the
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146 Purchasing and Supply Management
hospitality industry, the tangible side deals with how well customers’ food and drink
needs are met. The intangible side deals with the customer’s need to be liked, respected,
pampered, and treated as a valued client. Such needs are met when service personnel are
friendly, courteous, and enthusiastic; when they show they appreciate their customers’ patronage; when they are knowledgeable about the products they are selling; when they use
sales techniques tactfully and effectively; and when they strive to meet each customer’s
unique expectations for quality service.
Service can be classified by type as well as characteristics. Table 6–2 lists a variety of
common services. Service management texts provide a framework for identifying key service aspects for better analysis. They cover the value, degree of repetitiveness, tangibility,
or standardization, the nature of demand and service delivery, the direction and production
of the service, and the skills required for it. These nine factors alone create hundreds of
different combinations, a significant specification and acquisition challenge.
Every organization, whether in the manufacturing sector or the service sector, requires
services in the course of its operations. The service sector is growing as a portion of GDP
and so is the percent of spend for services. It is not only the sheer dollar volume spent to
acquire services but also the impact of these services on organizational success that makes
the effective acquisition of services a significant and important challenge.
Services which may be required by any organization are diverse. A brief and far-fromcomplete listing might include:
TABLE 6–2
Services
Advertising
Architectural
Auditing
Banking
Cafeteria/catering
Computer
programming
Construction
Consulting
Contract packaging
Courier services
Customs brokerage
Data processing
Demolition
Engineering design
Environmental
cleanup
Hazardous waste
disposal
Health benefit plans
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Household/office moves
Information systems
Inspections
Insurance
Interior decorating/space
planning
Janitorial
Research & development
Sales promotion
Security
Signage
Snow removal
Landscaping/lawn service
Legal service
Mail services
Maintenance
Medical
Payroll
Photography
Property management
Records management
Telephone
Temporary help
Training
Transport of goods
Trash removal/disposal
Travel (air, hotel, auto rental)
Utilities (electric, gas, water)
Vending service
Workers’ compensation
insurance
Space/storage rental
Recruiting/outplacement
Reproduction/copying
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Many services have traditionally been acquired directly by users outside the supply
area. However, concern over transparency, conflicts of interest, and value for money have
resulted in a shift of responsibility for service acquisition to supply professionals. That this
switch of responsibility has resulted in substantial benefits is clear. Therefore, continuing
greater involvement of supply professionals in service acquisition will increase supply’s
involvement percentage in the organization’s total spend in the years to come.
7. Other
The other category covers anything not included in the previous six categories and forms
a convenient catch-all.
Energy, water, and air are sometimes included in the MRO category. However, for
some organizations, energy and water, in particular, may be major expenditures and should
be managed quite differently from the MRO category.
Unusual and infrequent requirements by definition fall outside of the “normal” range
and have to be dealt with on an ad hoc or process basis. The purchase of a bronze statue
of the founder of the company for display in the corporate office lobby might qualify as
an example.
For all seven categories of needs the common acquisition challenge involves the determination of best buy under the circumstances. This requires recognizing not only the
traditional criteria of quality, quantity, delivery, and price, but also the risk and strategic,
environmental, technological, and social and political implications. Considerable judgment
may be required of the supply professional. Consultation with users, specifiers, customers,
regulators, financial, and other experts may have to precede the decision about what constitutes the best buy and what processes should be used to assure effective acquisition.
REPETITIVE OR NONREPETITIVE REQUIREMENTS?
For all seven categories of needs, the next question asks, “Repetitive or not?” For repetitive
requirements a system or process of acquisition can be designed. Accumulation of repetitive requirements over a specified period of time with the same supplier(s) may be sufficient volume for a purchase order or contract, avoiding the total acquisition process used
to select the supplier. Thus, after the trial period is over, the repetition becomes order, take
delivery, and pay in accordance with contract terms.
Another consideration for repetitive requirements concerns the length of time over
which this requirement will continue. For a manufacturer, this may relate to the product
life cycle and the design stability of the product. For a concrete block manufacturer, the
requirement for cement is likely to be very long term. Aside from the forecastability of
demand for a requirement, the supply manager may wish to consider for how long he
or she is willing to commit to a particular supplier. Generally, the shorter the contract,
the greater the flexibility to switch suppliers. Also, generally, the longer the contract
the price should be lower. Considerable judgment is required to deal effectively with
this trade-off.
For nonrepetitive requirements, depending on the category and the need criteria, an ad
hoc decision needs to be made regarding the process of acquisition. If the nonrepetitive
requirement is small and insignificant, having the user order it directly on a purchase card
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148 Purchasing and Supply Management
or treating it as a small value purchase may be adequate. On the other extreme, the acquisition of a multimillion-dollar piece of equipment may require the efforts of a project team
to finance, specify, and acquire the equipment.
COMMERCIAL EQUIVALENTS
Every acquisition is intended to fulfill a need. Therefore, the first step in the acquisition
process is to determine what is needed and why. The next step is to translate these needs
into commercial equivalents so that suppliers can understand what is needed. The temptation is to collapse these two steps into one. In consumer terms we say, “I need an aspirin,”
rather than “I need to cure my headache.” We say, “I need a nail to nail two pieces of wood
to each other,” rather than “I need to fasten these two pieces of wood together.” Why this
distinction is important is explained next.
It has become generally recognized that about 70 percent of the opportunity for value
improvement lies in the first two phases of the acquisition process: (1) need identification
and (2) specification. Therefore, great attention needs to be paid to ensure that value opportunities are not overlooked (see Figure 6–1).
Many options exist for fastening two pieces of wood together. Using a nail is only one
option. Grooving the two pieces of wood using a staple, bolt or screw, or glue are others.
Specifying the need first and then identifying the variety of options to meet the need leave
the door open to lower cost and better, or more innovative, solutions. If the supply professional has reason to believe that further opportunities exist to improve on the commercial
equivalent presented by a designer or specifier, he or she has the responsibility to bring this
to the attention of the designer or specifier. Early supply and supplier involvement prevents
the hassles associated with trying to reverse a design decision after it has been made and
approved technically.
Opportunity
to Affect Value
during the Six
Steps of the
Acquisition
Process
High
Opportunity to
Affect Value
FIGURE 6–1
Low
1.
Need
Recognition
2.
Description
3.
Potential
Suppliers
4.
Selection
5.
Receipt
6.
Payment
Acquisition Process Chart
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EARLY SUPPLY AND SUPPLIER INVOLVEMENT
Given the high opportunity to affect value during the need identification and specification
stages, it is essential that supply considerations are brought to bear on decisions during
these two stages. This is fundamental in value analysis/value engineering. Early supply
involvement and early supplier involvement (ESI) help assure that what is specified is also
procurable and represents good value. Various organizational approaches, such as staffing
the supply area with engineers, co-locating supply people in the engineering or design
areas, and using cross-functional teams on new product development or product or service
reviews, have been used to address effective early supply involvement.
The second step in the acquisition process involves (ranking) the organization’s needs
into commercial language so that suppliers can understand what is required. This requires
not only an understanding of what the market can supply, but also which type of description might be preferable under the circumstances.
METHODS OF DESCRIPTION
The using, requesting, or specifying department must be capable of reasonably describing
what is required to be sure of getting exactly what is wanted.
Although the prime responsibility for determining what is needed usually rests with
the using or specifying department, the supply department has the direct responsibility of
checking the description given. Supply professionals should, of course, not be allowed to
alter arbitrarily the description or the quality. They should, however, have the authority to
insist that the description be accurate and detailed enough to be perfectly clear to every potential supplier. The supply professional also must call to the attention of the requisitioner
the availability of other options that might represent better value.
The description of an item may take any one of a variety of forms or, indeed, may be
a combination of several different forms. For our discussion, therefore, description will
mean any one of the various methods by which a buyer conveys to a seller a clear, accurate
picture of the required item or service. The term specification will be used in the narrower
and commonly accepted sense referring to one particular form of description.
The methods of description will be discussed in order:
1. By brand
2. “Or Equal.”
3. By specification.
a. Physical or chemical characteristics.
b. Material and method of manufacture.
c. Performance.
4. By engineering drawing.
5. By miscellaneous methods.
a. Market grades.
b. Sample.
6. By a combination of two or more methods.
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150 Purchasing and Supply Management
Brand
There are two questions of major importance in connection with the use of branded items.
One relates to the desirability of using this type of description and the other to the problem
of selecting the particular brand.
Description by brand or trade name indicates a reliance on the integrity and the reputation of the supplier. It assumes that the supplier is anxious to preserve the goodwill attached to a trade name and is capable of doing so. Furthermore, when a given requirement
is purchased by brand and is satisfactory in the use for which it was intended, the purchaser
has every right to expect that any additional purchases bearing the same brand name will
correspond exactly to the quality first obtained.
There are certain circumstances under which description by brand is desirable and
necessary:
1. When, either because the manufacturing process is secret or because the item is covered
by a patent, specifications cannot be laid down.
2. When specifications cannot be laid down with sufficient accuracy by the buyer because
the supplier’s manufacturing process calls for a high degree of that intangible labor
quality sometimes called expertise or skill, which cannot be defined exactly.
3. When the quantity bought is so small as to make the setting of specifications or testing
by the buying organization unduly costly.
4. When end customers or users have real, even if unfounded, preferences in favor of
certain branded items, a bias the supply professional may find almost impossible to
overcome.
On the other hand, there are objections to purchasing branded items, most of them turning on cost. Although the price may often be quite in line with the prices charged by other
suppliers for similarly branded items, the whole price level may be so high as to cause
the buyer to seek unbranded substitutes. Thus, the purchaser may just as well prefer using
trisodium phosphate over a branded cleaning compound costing 50 percent to 100 percent
more.
A further argument frequently encountered against using brands is that undue dependence on brands tends to restrict the number of potential suppliers and deprives the
buyer of the possible advantage of a lower price or even of improvements brought out by
competitors.
“Or Equal”
It is not unusual, particularly in the public sector, to see requests for quotations or bids that
will specify a brand or a manufacturer’s model number followed by the words “or equal.”
In these circumstances, the buyer tries to shift the responsibility for establishing equality or
superiority to the bidder without having to go to the expense of having to develop detailed
specifications.
Specification
Specification constitutes one of the best known of all methods employed. A lot of time
and effort has been expended in making it possible to buy on a specification basis.
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Closely related to these endeavors is the effort toward standardization of product specifications and reduction in the number of types, sizes, and so on of the products accepted
as standard.
It is becoming common practice to specify the test procedure and results necessary
to meet quality standards as part of the specification as well as instructions for handling,
labeling, transportation, and disposal to meet environmental regulations.
Traditional advantages of buying with specifications include:
1. Evidence exists that thought and careful study have been given to the need and the ways
in which it may be satisfied.
2. A standard is established for measuring and checking materials as supplied, preventing
delay and waste that would occur with improper materials.
3. An opportunity exists to purchase identical requirements from a number of different
sources of supply.
4. The potential exists for equitable competition. This is why public agencies place
such a premium on specification writing. In securing bids from various suppliers,
a buyer must be sure that the suppliers are quoting for exactly the same material or
service.
5. The seller will be responsible for performance when the buyer specifies performance.
Seven limitations in using specifications, assuming the buying organization is capable of
specifying, are:
1. There are requirements for which it is practically impossible to draw adequate specifications.
2. The use of specifications adds to the immediate cost.
3. The specification may not be better than a standard product, readily available.
4. The cost is increased by testing to ensure that the specifications have been met.
5. Unduly elaborate specifications sometimes result in discouraging potential suppliers
from placing bids in response to inquiries.
6. Unless the specifications are of the performance type, the responsibility for the adaptability of the item to the use intended rests wholly with the buying organization.
7. The minimum specifications set up by the buying organization are likely to be the
maximum furnished by the supplier.
Specification by Physical or Chemical Characteristics
Specification by physical or chemical characteristics provides definitions of the properties
of the materials the purchaser desires. They represent an effort to state in measurable terms
those properties deemed necessary for satisfactory use at the least cost consistent with quality.
Specification by Material and Method of Manufacture
The second type of specification prescribes both the material and method of manufacture.
Outside of some governmental purchases, such as those of the armed forces, this method
is used when special requirements exist and when the buying organization is willing to
assume the responsibility for results. Many organizations are not in this position, and as a
result, comparatively little use is made of this form of specification.
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152 Purchasing and Supply Management
Specification by Performance or Function
The heart of performance specification is the understanding of the required functions. It is
not easy to think of the basic function the item must perform. We tend to speak of a box
instead of something to package in, a bolt instead of something that fastens. We think of a
steak, instead of something to eat, and a bed, instead of something to sleep on.
Performance or function specification in combination with a request for proposal (RFP)
is employed to a considerable extent, partly because it throws the responsibility for a satisfactory product or service back to the seller. Performance specification is results and
use oriented, leaving the supplier with the decisions on how to provide the most suitable
product or service. This enables the supplier to take advantage of the latest technological
developments and to substitute anything that exceeds the minimum performance required.
The satisfactory use of a performance specification, of course, is absolutely dependent
on securing the right kind of supplier. It should be noted that it may be difficult to compare
quotations and the supplier may include a risk allowance in the price.
Description by Engineering Drawing
Description by a design or dimension sheet is common and may be used in connection with
some form of descriptive text. It is particularly applicable to the purchase of construction,
electronic and electrical assemblies, machined parts, forgings, castings, and stampings. It
is an expensive method of description not only because of the cost of preparing the print or
computer program itself but also because it is likely to be used to describe an item that is quite
special as far as the supplier is concerned and, hence, expensive to manufacture. However, it
is probably the most accurate of all forms of description and is particularly adapted to acquiring those items requiring a high degree of manufacturing perfection and close tolerances.
Miscellaneous Methods of Description
There are two additional methods of description: description by market grade and description by sample.
Description by Market Grades
Purchases on the basis of market grades are confined to certain primary materials. Wheat
and cotton,1 lumber, steel, and copper are commodities. For some purposes, purchase by
grade is entirely satisfactory. Its value depends on the accuracy with which grading is done
and the ability to ascertain the grade of the material by inspection.
Furthermore, the grading must be done by those in whose ability and honesty the purchaser has confidence. It may be noted that even for wheat and cotton, grading may be
entirely satisfactory to one class of buyer and not satisfactory to another class.
Description by Sample
Still another method of description is by submission of a sample of the item desired. Almost all
purchasers use this method from time to time but ordinarily (there are some exceptions) for a
minor percentage of their purchases and then more or less because no other method is possible.
1
For agricultural raw materials, such as wheat and cotton, the grades are established by the U.S.
Department of Agriculture. They include all food and feed products, the standards and grades for which
have been established in accordance with the Federal Food and Drug Act, the Grain Standards Act, and
other laws enacted by Congress. Establishing grades acceptable to the trade is essential to the successful
operation of a commodity exchange.
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Good examples are items requiring visual acceptance such as wood grain, color, appearance, smell, and so on.
Combination of Descriptive Methods
An organization frequently uses a combination of two or more of the methods of description already discussed. The exact combination found most satisfactory for an individual
organization will depend, of course, on the type needed by the organization.
Sources of Specification Data
Speaking broadly, there are three major sources from which specifications may be derived:
(1) individual standards set up by the buying organization; (2) standards established by certain
private agencies, either other users, suppliers, or technical societies; and (3) governmental
standards.
Individual Standards
Individual standards require extensive consultation among users, engineering, supply, quality control, suppliers, marketing, and, possibly, ultimate consumers. This means the task is
likely to be arduous and expensive.
A common procedure is for the buying organization to formulate its own specifications
on the basis of the foundation laid down by the governmental or technical societies. To
make doubly sure that no serious errors have been made, some organizations send out copies of all tentative specifications, even in cases where changes are mere revisions of old
forms, to several outstanding suppliers in the industry to get the advantage of their comments and suggestions before final adoption.
Standard Specifications
If an organization wishes to buy on a specification basis, yet hesitates to undertake to originate
its own, it may use one of the so-called standard specifications. These have been developed as
a result of a great deal of experience and study by both governmental and nongovernmental
agencies, and substantial effort has been expended in promoting them. They may be applied
to raw or semimanufactured products, to component parts, or to the composition of material.
The well-known SAE steels, for instance, are a series of alloy steels of specified composition
and known properties, carefully defined, and identified by individual numbers.
When they can be used, standard specifications have major advantages. They are
widely known and commonly recognized and readily available to every supply professional. Furthermore, the standard should have somewhat lower costs of manufacture. They
have grown out of the wide experience of producers and users, and, therefore, should be
adaptable to the requirements of many users.
Standard specifications have been developed by a number of nongovernmental engineering and technical groups. Among them may be mentioned the American Standards Association, the American Society for Testing Materials, the American Society of Mechanical
Engineers, the American Institute of Electrical Engineers, the Society of Automotive Engineers, the American Institute of Mining and Metallurgical Engineers, the Underwriters
Laboratories, the National Safety Council, the Canadian Engineering Standards Association,
the American Institute of Scrap Recycling Industries, the National Electrical Manufacturers’
Association, and many others.
While governmental agencies have cooperated closely with these organizations, they
have also developed their own standards. The National Bureau of Standards in the U.S.
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154 Purchasing and Supply Management
Department of Commerce compiles commercial standards. The General Services Administration coordinates standards and federal specifications for the nonmilitary type of items
used by two or more services. The Defense Department issues military (MIL) specifications.
The American National Standards Institute (ANSI) is a private, nonprofit organization
that administers and coordinates the U.S. voluntary standardization system. Its mission is
to enhance U.S. global competitiveness and the American way of life by promoting, facilitating, and safeguarding the integrity of the voluntary standardization system.2
Developed by ANSI, National Resource for Global Standards, NSSN, contains more
than 250,000 references to standards from more than 600 developers worldwide. ANSI
provides access to various U.S. and global standards on its Web site, and can be a valuable
resource for purchasers who need access to various standards.3
Government, Legal, and Environmental Requirements
Federal legislation concerning environmental factors, employee health and safety, security,
and consumer product safety requires vigilance on the part of supply professionals to be
sure that products purchased meet government requirements. The Occupational Safety and
Health Administration (known as OSHA) of the U.S. Department of Labor has broad powers to investigate and control everything from noise levels to sanitary facilities in places of
employment. The Consumer Product Safety Act gives broad regulatory power to a commission to safeguard consumers against unsafe products. Supply professionals have the
responsibility to make sure that the products they buy meet the requirements of the legislation. Severe penalties, both criminal and civil, can be placed on violators of the regulations.
STANDARDIZATION AND SIMPLIFICATION
The terms standardization and simplification are often used to mean the same thing.
Strictly speaking, they refer to two different ideas. Standardization means agreement on
definite sizes, design, quality, and the like. It is essentially a technical and engineering
concept. Simplification refers to a reduction in the number of sizes, designs, and so forth. It
is a selective and commercial problem, an attempt to determine the most important sizes,
for instance, of a product and to concentrate production or use on these wherever possible.
Simplification may be applied to articles already standardized as to design or size or as a
step preliminary to standardization.
The challenge in an organization is where to draw the line between standardization and
simplification, on the one hand, and suitability and uniqueness, on the other. Clearly, as
economic and technological factors change, old standards may no longer represent the best
buy. Frequently, by stressing standardization and simplification of the component parts,
rather than the completed end product, production economies may be gained, combined
with individuality of end product. Simultaneously, procurement advantages are gained in
terms of low initial cost, lower inventories, and diversity in selection of sources. The automotive industry, for example, has used this approach extensively to cut costs, improve
quality, and still give the appearance of extensive consumer options.
2
3
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American National Standards Institute, www.ansi.org, January 2001.
See www.nssn.org or www.ansi.org.
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Chapter 6 Need Identification and Specification
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Sasib, a manufacturer of equipment for the food and beverage industry, headquartered
in Italy, found that product standardization was an important issue for its large global customers, such as Coca Cola and Heineken. The chief purchasing officer described the importance of standardization and the role of supply: “Standardization is important to us, not
just for leveraging purchases across the group, but also in terms of our ability to design and
build a product for our customer that is consistent, regardless of where it is manufactured.
We also want to be able to exchange and optimize manufacturing capacity. For example,
we need to develop the flexibility to build machines in the United States that are designed
in Europe and vice versa. More importantly, our customers are expecting standardization
across our product lines. This can only be done if we use the same suppliers that can provide support everywhere in the world. Consequently, we use top-quality suppliers with
global supply and service networks. Previously, the companies were dealing with local
suppliers. Even in situations where divisions used common suppliers, prices and specifications differed substantially.”4
Conclusion
Need definition and translation of needs into commercial equivalents are the first two steps
in the acquisition process. Needs are qualified at three levels. At level 1 needs are defined
as strategic or nonstrategic. At level 2, quality, quantity, delivery, price, and service form
the traditional value criteria for any acquisition. Level 3 criteria include additional financial considerations beyond price, risk, the environment, innovation, and social and political concerns. Considerable judgment is required of the supply professional to include the
relevant criteria for specific needs. Needs or requirements cover seven major categories:
(1) resale, (2) raw and semiprocessed materials, (3) parts, components, and packaging,
(4) maintenance, repair, and operating supplies, (5) capital and service, and (7) other.
Supply professionals may specialize in one or several of these categories to become
fully acquainted with specific markets and suppliers. Translating organizational needs into
commercial equivalents is the second step of the acquisition process and affords many
opportunities for value improvements. Early supply and supplier involvement in the first
two steps in the acquisition process is essential for effective value improvements. There
are many methods of description of organizational needs, each with its own advantages
and disadvantages. Lastly, standardization and simplification are used to improve value by
reducing the number and variety of requirements.
4
Michiel R. Leenders and P. Fraser Johnson, Major Structural Changes in Supply Organizations (Tempe AZ:
Center for Advanced Purchasing Studies, 2000).
Questions
for
Review
and
Discussion
joh77899_ch06_135-164.indd 155
1. Why is it preferable to separate need identification and defining commercial equivalents into two separate stages?
2. Why is early supply/supplier important?
3. Why is capital goods acquisition different from the purchase of raw materials?
4. What are some major challenges in the acquisition of services? Please use examples.
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156 Purchasing and Supply Management
5. What are some effective supply methods for dealing with maintenance, repair, and
operating (MRO) requirements?
6. Compare the acquisition of resale requirements to the acquisition of parts, components,
or packaging.
7. Why should a supply professional acquire by “brand”?
8. What are the disadvantages of specifying by performance? What are the advantages?
9. What is the difference between standardization and simplification?
10. How does a supply professional know that a certain requirement is strategic?
11. How would you determine the environmental impact of a particular acquisition?
References
American National Standards Institute, www.ansi.org.
Askin, Ronald G., and Jeffrey B. Goldberg. Design and Analysis of Lean Production
Systems, New York: Wiley, 2001.
Axelsson, Bjorn, and Finn Wynstra. Buying Business Services. West Sussex, U.K.: John
Wiley & Sons, 2002.
Contino, Richard. The Complete Equipment-Leasing Handbook. New York: AMACOM,
2002.
Duffy, Roberta J., and Anna E. Flynn. “Services Purchases: Not Your Typical Grind.”
Inside Supply Management 14, no 9, September 2003, p. 28.
Ellram, L. M.; W. L.; Tate and C. Billington. “Understanding and Managing the Services
Supply Chain.” Journal of Supply Chain Management 40, no. 3 (2004), pp. 17–32.
Managing Your “Service Spend” in Today’s Service Economy. CAPS Research, July 22,
2003.
Ritzman, Larry P.; Lee J. Krajewski; and Robert D Klassen. Foundations of Operations
Management. Pearson Prentice Hall: Toronto, 2004.
Smeltzer, Larry A., and Jeffrey A. Ogden. “Purchasing Professions’ Perceived Differences
between Purchasing Materials and Purchasing Services.” Journal of Supply Chain
Management 38, no. 1, Winter 2002, p. 54.
Wade, D. S. Managing Your “Services Spend” in Today’s Services Economy. Tempe, AZ:
CAPS Research, 2003.
Case 6–1
Moren Corporation (A)
Moren Corporation was building three additional generation
stations to serve its rapidly expanding energy market. To
link these stations with a total area grid, a new method of carrying the power lines using ornamental tubular poles instead
of towers had been adopted. Moren had had no previous operating experience with poles and decided to subcontract the
design engineering, fabrication, and erection of the new line.
joh77899_ch06_135-164.indd 156
For the first phase of engineering design, Mr. Carter,
the vice president of supply, faced the responsibility of deciding with which supplier the business was to be placed
after his staff had developed the information needed. He
was aware that Moren had only three years in which to
complete the entire project, and yet he had to ensure highquality work.
6/9/10 9:40 PM
Chapter 6 Need Identification and Specification
COMPANY BACKGROUND
Moren Corporation, established in 1895, was one of the
largest power utilities in the eastern United States. It
serviced a highly industrialized area of 10 fossil-fueled
plants. With assets of over $19 billion and demand doubling every decade, it had already earmarked funds to increase its kilowatt capacity from 8.4 million to 13 million
over a four-year period.
The company was well known for its advanced technology and its good public relations. Both purchasing and
engineering departments were centralized and located in
the head office in the area’s largest city. The new construction program was a heavy strain on both the professional and financial resources of the company, placing
increased emphasis on the use of qualified people and
suppliers outside the corporation.
TRANSMISSION LINE BACKGROUND
Although Moren was stepping up its older lines to 230 kV,
by management decision and in accordance with the technological trend, 345 kV was adopted for the new line.
It was to link the new generating stations in Addison,
Smithfield, and Mesa Valley with the area grid, some
140 miles in total.
Until now, Moren had used structural steel towers exclusively for carrying its power line. These were strong
but visually prominent and attracted adverse comments
from a public daily growing more aesthetically sophisticated. A relatively new development in the transmission
field was the introduction of the ornamental tubular power
pole. Approximately 2,000 miles of line using these poles
had been installed with good success in various parts of
the country. Most installations were relatively short sections in densely populated areas. A line using poles costs
twice as much as the conventional towers but is still substantially cheaper than underground installation. Conscious of the great strides made in power pole design and
use, Moren management decided to specify poles for the
new lines.
Because of the volume of conversion and projected expansion work, Mr. Carter and the project engineers knew
that the tower manufacturers and erection companies with
whom they had dealt in the past would not have the capacity to handle all the elements of the new pole concept.
Furthermore, with no experience in 345 kV or pole suspension, Moren had to reply on the know-how of others
for the new line and needed the services and guidance of
competent subcontractors.
joh77899_ch06_135-164.indd 157
157
The total job involved three major phases.
1. Engineering design called for layout as well as a functional pole specification and project guidance.
2. Pole manufacture involved a manufacturing proposal
consisting of a specific design to meet the functional
specifications as well as manufacturing volume and
schedule deadline capabilities.
3. Pole installation involved excavation, foundation setting, pole erection, and line stringing. Preliminary cost
estimates for the total project were as follows:
a. Phase 1—Engineering: $1,500,000–$1,800,000
b. Phase 2—Pole manufacture: $90 million
c. Phase 3—Installation: $78 million
Mr. Carter and the chief engineer were not satisfied
that any individual supplier could handle the total contract
well. They decided, therefore, to subcontract each phase
to a reliable source of high expertise within that phase, so
that optimum overall benefits would accrue to Moren. The
first sourcing decision dealt with the engineering phase.
DESIGN ENGINEERING SELECTION
All through the spring and half of the summer Oliver
Dunn, the buyer, worked with the transmission engineering section of the system engineering department of the
company to establish parameters and locate a suitable design source. By late July he was able to make his recommendation to the director of purchases (see Exhibit 1).
It was normal practice at Moren to provide a very brief
summary for the director of purchases on all major contracts. A large file containing detailed information was
built up by the buyers and purchasing agents involved.
Normally, some preliminary discussions were held as the
project progressed, so that Mr. Carter was reasonably informed by the time the official recommendation was prepared. Should he wish to see more information he could
request the file at any time.
All three of the engineering firms considered were
large and engaged in a wide variety of engineering consulting services. Travers & Bolton (T&B) and Crown
Engineering (CE) had both done considerable work
for Moren in the past and had performed satisfactorily.
Pettigrew Associates had its head office in New York and
maintained branches in 10 American cities. Pettigrew
employed over 3,800 people, had a good credit rating,
and had annual sales in excess of $480 million per year.
Moren had never used Pettigrew in any of its projects.
All three engineering firms had some tubular pole experience with short-line sections in other parts of the country.
6/9/10 9:40 PM
158 Purchasing and Supply Management
EXHIBIT 1
Quotation
Summary
Description
Recommended vendor:
Location: Their premises
Buyer: O. Dunn
P.O. No.:
Design 140 miles 345 kV transmission line for
Addison-Smithfield-Mesa Valley
Pettigrew Associates, New York, N.Y.
Using department: General engineering
Total value: Established $1,740,000
salaries ⫹ burden
Date
Approval:
Aside from the design requirements, the consulting engineering firm was also expected to evaluate the bids from
pole manufacturing and erection subcontractors.
Additional Information
1. The transmission section of our general engineering
department is unable to perform the design work of all
the planned transmission work for the next three years,
and it is necessary to contract some portion of this work.
Travers & Bolton are already assigned the conversion
of the 120kV to 230, and it is recommended that this
140-mile Addison-Smithfield-Mesa Valley 345 kV be
contracted to some competent engineering firm.
Supplier
Estimated
Labor-Hours
Basic Average
Cost per
Labor-Hour
(w/o fringes)
Travers & Bolton
Crown Engineering
Pettigrew Associates
14,350
–
12,190
$60.00
$60.00
$60.00
It is recommended that this contract be awarded to
Pettigrew even though their cost per hour is higher than
the others. Total cost will be influenced by the capabilities
and productivity of the company chosen, and, therefore,
2. We had sessions with each of the three below mentioned engineering firms to acquaint them with our
needs and learn of their capabilities. The work they
will perform is as follows: Make routine sections;
make subsurface investigations; make electrical hardware and general project designs; and furnish miscellaneous specifications, drawings, and technical data
required to procure the right of way, hardware, structural steel, and the awarding of contracts for construction. It is estimated this work will total 12,300 laborhours. There will also be approximately $144,000
worth of computer services and general out-of-pocket
expenses in addition to the labor-hours.
3. Bid comparison is:
Approximately
Fringes
(assumed
same for all)
Overhead and
Profit
Estimated
$/hour
20%
20
20
65.5%
80.0
85.0
$120.00
$129.60
$133.20
Pettigrew may not cost us any more; it is the desire of
Moren management to have Pettigrew perform such a job
with Moren as our first experience with them. Both T&B
and CE have done considerable work for Moren.
Case 6–2
Moren Corporation (B)
Moren Corporation was building three additional generating stations to serve the rapidly expanding energy
market. To link these stations with the total area grid, a
new method of carrying the power lines using ornamental
joh77899_ch06_135-164.indd 158
tubular poles instead of towers had been adopted. Moren
lacked experience with poles and decided to subcontract
the design engineering, fabrication, and erection of the
new line. [For company background and line projection
6/9/10 9:40 PM
Chapter 6 Need Identification and Specification
information and the selection of engineering consultants
see Moren (A) case.]
Having selected its consultants for its first 345 kV
transmission line and placed its order for the fabrication
of the poles and hardware, Moren was ready to locate a
suitable contractor to do the foundation work, erect the
poles, and string the lines.
Purchasing and engineering had been pursuing this
concurrently with the search for a fabricator, because
Moren wanted to get started on the line by the fall.
Gordon Yarrow, supervisor of materials purchasing, was
responsible to the vice president of supply, John Carter,
for this contract.
CONSTRUCTION SELECTION
One company, T. D. Rapier, had done almost all Moren’s
transmission work for over the last five years, but, with
the consultant’s help, a good cross section of qualified
line builders had been invited to bid. In addition, several
foundation companies were asked to quote on the subgrade work. This helped to test the market to determine
whether foundation contractors could build foundations
cheaper than line builders. Mr. Carter reserved the right
to award separate contracts for above- and below-grade
work.
Two meetings were held with the bidders, one for the
line builders and another for the foundation contractors,
at which all aspects of the job were fully discussed. The
unit prices were based on current wage rates and working
conditions and were subject to adjustment by a percentage
equal to 0.80 times the percentage change in the average
wage rates.
By September the consulting engineers were able to
provide purchasing with an evaluation of the bidding and
computation, enabling the attached summary to be compiled (see Exhibit 1).
Notes
1. Two line contractors and one foundation contractor
declined to bid.
2. The two lowest line constructors, Rapier and
McTaggart, were evaluated, plus the possibility of a
split award to (L) for foundations and (I) for abovegrade work. However, McTaggart is recommended for
the following reason:
a. Offers lowest bid.
b. Highly experienced. Built thousands of miles of
line in mountain, desert, and swamp. Experience
included 230, 345, 500, and 750 kV construction.
c. Presently working for several other power companies.
d. Recommended by our design engineers and
consultants.
e. Has done considerable work in this state through a
subsidiary, although not for Moren.
EXHIBIT 1
Moren
Corporation—
345 kV
Transmission
Line AddisonSmithfieldMesa Valley
joh77899_ch06_135-164.indd 159
159
Comparison of
Bids
Bidder
Line contractors
(D)
(E)
(F)
(G) T.D. Rapier
(H) McTaggart Construction
(I)
Consulting engineer’s prior estimate
Foundation contractors:
(J)
(K)
(L)
Line
Construction
Foundation
Installation
$47,103,840
38,117,804
41,390,640
37,485,360
43,433,700
36,192,072
47,750,400
$53,079,648
44,617,110
37,778,478
37,993,872
27,672,804
No bid
30,612,400
Total
$100,183,488
82,734,914
79,169,118
75,479,232
71,106,504
78,362,800
73,775,574
38,966,364
35,201,376
6/9/10 9:40 PM
160 Purchasing and Supply Management
Case 6–3
Carson Manor
In late November, Ms. Elaine Taylor, director of supply
for the city of Winston, was reviewing proposals for the
Carson Manor study. Three consulting groups had responded to a request for proposal (RFP) to study the operation of the city-owned old-age home. Ms. Taylor knew
that her recommendations for selection of a consultant
would have to be completed by mid-December.
CARSON MANOR
Carson Manor was opened about 30 years ago for persons
requiring nursing care. Carson had a bed capacity of 470.
Staff totaled 235 with nonmanagement personnel unionized under the District Service Workers Union Local 325.
Day-to-day operations of the Carson Manor were the
responsibility of the Carson Manor administrator, who
reported to Mr. Henry Davis, the city’s director of social services. Policy and budget plans were developed by
Mr. Davis and his staff in conjunction with Carson administrative staff and the Carson Manor Committee of
Management (CMCM). The CMCM consisted of five
aldermen who were appointed or volunteered to fill these
positions. The CMCM reported to another aldermanic
committee, with broader community service concerns,
EXHIBIT 1
called the Committee for Community Services. This
committee reviewed major expenditures and decisions
impacting community service policy. All major expenditures were then reviewed by the Board of Control, consisting of the mayor and four elected controllers, prior to
being sent to city council for final approval.
As director of social services, Mr. Davis reported to
the city administrator, Mr. J. Peterson, who in turn reported to the mayor. The combined elected and appointed
reporting structure is shown in Exhibit 1.
PURCHASING AND SUPPLY
DIVISION (PSD)
The PSD had purchasing and disposal authority for the
city’s engineering, fire, landfill/sanitation departments,
and social services division, and for city hall building
support. The city operated separate purchasing departments in the public utilities commission, the libraries, and
the police department. Purchasing authority was granted
to the PSD director and her buyers by municipal bylaw.
This bylaw outlined the limits of purchasing authority and
formed the basis of the PSD’s Policy Manual for Purchasing, Tendering, and Disposal.
Mayor
Reporting
Structure
City Administrator
Mr. J. Peterson
City Council
Board of Control
Director of Social
Services
Mr. H. David
City Treasurer
Mr. R. Holbright
Committee for
Community Services
Carson Manor
Committee of
Management
joh77899_ch06_135-164.indd 160
Carson Manor
Administration
Director of Supply
Ms. E. Taylor
6/9/10 9:40 PM
Chapter 6 Need Identification and Specification
The main objective of the PSD was to respond to the
needs of other departments and divisions for goods and
services at minimum cost, consistent with desired quality, delivery timing, and reliability. The PSD had expertise in the purchasing and tendering of goods and certain
services, such as equipment rental, maintenance contracts,
and engineering/architectural consulting. However, it had
not dealt extensively with management consulting service
procurement at that time.
Elaine Taylor became director of PSD two years ago at
the age of 35. Prior to this, she was chief buyer and assistant director of purchasing for the city of Forestview, similar in size to Winston. Elaine reported to the city treasurer,
Mr. R. Holbright, and dealt directly with other department
and division heads on purchasing matters, as shown in Exhibit 1. She managed a staff of 15, including three buyers.
THE CARSON MANOR STUDY
The Carson Manor had a history of problems related
to budgeting and cost control. City council felt that the
cost per bed was unnecessarily high, when compared to
privately run institutions. Eight months ago the council
directed the city administrator, Mr. Peterson, and the
161
director of social services, Mr. Davis, to prepare a report
for submission to the Carson Manor Committee of Management in early June. The report was to contain:
1. An analysis of the comparative costs at Carson Manor
and other state facilities.
2. A review of the feasibility of increasing cost efficiency.
3. A review of the implications of possible alternatives
such as:
a. Contract management.
b. An in-depth operational review and cost efficiency
study carried out by an external agency.
The requested internal report, titled “The Carson Manor
for the Aged, a Review and Alternatives,” was tabled on
June 9. It revealed that Carson Manor costs were approximately 14 percent higher than state averages on a per-bed
basis. The report highlighted the difficulties of measuring and controlling costs in the absence of a patient classification system that would enable standard levels of
nursing care to be developed. The report recommended
an operational review by an outside agency and outlined
some general guidelines and objectives. Sections of the
internal report, related to these guidelines and objectives,
are shown in Exhibit 2.
EXHIBIT 2 Carson Manor
Excerpts from “The Municipal Home for the Aged, a Review and Alternatives.” A report to the Carson Manor
Committee of Management by J. Peterson, City Administrator, and H. Davis, Director of Social Services.
Page 29
Increasing levels of care required by Carson Manor residents have a major influence on costs, since care
essentially is translated into staff to provide the necessary services. No objective classification of resident
care requirements has ever been carried out at the Carson Manor although there is no question that current
residents and even new applicants require much more nursing care than was formerly the case.
Page 33
An operational review could be carried out by an independent consulting firm of the State’s Department
of Community and Social Services and would provide a thorough analysis of options and possible areas for
improvement at the Carson Manor.
Such an approach would provide a firm basis for the development of strategies for operational change but
would not guarantee implementation of the necessary changes.
Page 34
The overall advantage of an operational review would be the ability to identify, in depth, problem areas at
the Carson Manor for which change strategies could be developed by the city. Such strategies might include
contract management of a specific service, for example. This type of analysis would provide solid ground
for future planning. On the negative side of the balance are the costs of such a study and the necessity to
subsequently develop and implement changes for the identified problem areas.
joh77899_ch06_135-164.indd 161
6/9/10 9:40 PM
162 Purchasing and Supply Management
EXHIBIT 3 Request for Proposal
You are invited to submit a proposal for the purpose of conducting an administrative and operational review
of the Carson Manor for elder citizens. The review is to include all aspects of operation at the home, including, but not restricted to, assessment of resident care requirements, review of administration, organizational
design, and staffing. The main sections of the home include laundry and housekeeping, nursing and physiotherapy, dietary, special services, property, building maintenance, and administration. The review is to be
conducted by examination and administration.
On the basis of the review, you are to develop comprehensive recommendations for introducing improved
operating and cost efficiencies for the future operation of the home. All recommendations should offer alternatives, identify savings to be achieved and the related cost in order to implement the recommendations, projected impact on staff and administration, and strategies for implementation that are consistent with the city’s
role as operators of the home, as well as provisions for ensuring the maintenance of the current quality of care.
It is our intent that the cost of the review and subsequent implementation of the recommendations is to
be recovered from savings achieved in the operations of the home.
Your Proposal Is to Include the Following Information
a. Proposed methodology for undertaking the review.
b. Names and qualifications of persons to be involved in the review and development of subsequent
recommendations.
c. An estimate of the time required to undertake the review and develop the recommendations.
d. Documentation and references demonstrating your ability to successfully implement recommendations in
similar circumstances.
e. Potential cost savings that may be achieved as a result of the review.
f. A copy of any contracts or agreements that are to be entered into as a result of being retained to conduct the review.
It is to be noted that your fee structure including upset limits is to be identified separately; however,
included in the operating cost, calculations with the savings are to be shown as a net amount.
Council accepted the report’s recommendations and
directed Messrs. Peterson and Davis to initiate an independent consultant’s study of Carson Manor. This was not
a budgeted expense and the approval of the CMCM, the
Committee of Community Services, the Board of Control,
and City Council were necessary prior to letting a consulting contract. Mr. Davis requested the assistance of Elaine
Taylor and the PSD in identifying and evaluating potential study participants. Elaine Taylor handled the Carson
Manor Study personally, since it was beyond the scope of
responsibilities and experience of her buyers. She drafted
an RFP, which is shown in Exhibit 3. In-state consulting organizations were contacted and a list of consulting
companies with relevant experience was developed. Five
consulting companies were invited to submit proposals.
Prebid conferences were held in September. The consulting companies sent representatives for preliminary inspections of Carson Manor and for informal discussions
of the scope, terms of reference, and evaluation criteria to
be used in the proposal evaluation. Three proposals were
joh77899_ch06_135-164.indd 162
submitted by closing, on November 17, with the following cost breakdown.
Proposal
Patientcare Ltd.
Clarke-Hamilton Ltd.
Standardcare Ltd.
Bid
$35,000
47,000
77,000
Patientcare and Standardcare were both large operators of nursing homes; Clarke-Hamilton was a management consulting firm located 100 miles away.
Prior to evaluating the bids, Elaine summarized the proposals as shown in Exhibit 4. As she sat preparing to evaluate the proposals, she wondered what evaluation criteria
and weightings she should use, keeping in mind the needs
of the social services division and the content of the RFP.
In addition, she knew that her recommendations and
justifications had to be forwarded to the city administrator by December 19, prior to seeking approval of the various committees of elected officials.
6/9/10 9:40 PM
Chapter 6 Need Identification and Specification
163
EXHIBIT 4 Proposals for Carson Manor Review
1. Methodology
Patientcare
Clarke-Hamilton
Require liaison person from
city administration to assist
team.
Suggest a steering committee be formed from city
management and Carson
Manor administration.
1.
2.
3.
4.
5.
6.
7.
8.
9.
2. Anticipated
Reduction and
Implementation Costs
Collect data.
Review program.
Conduct interviews.
Determine and
evaluate operational
policies.
Analyze staff and cost.
Evaluate financial
situation.
Prepare report of funds
and recommendations.
Administration and
project control.
Provide assistance
with implementation if
required.
– Intend to utilize Department of Health
general guidelines
for work standards/
patient classifications with judgment
applied.
– May not leave Home
with a system to use
in the future.
“Patientcare is prepared to
estimate the sum of all proposed operating deficiencies; if implemented, cost
would far exceed the cost
of the study and would be
at least $700,000.”
1. Discuss terms of
review with steering
committee.
2. Examine pertinent
documentation.
3. Review all sections.
4. Conduct interviews
and physical tour.
5. Identify opportunities
for improvement in all
sections.
6. Develop detailed
recommendations.
7. Review recommendations with
Management.
8. Prepare and present
final report.
9. Implement recommendations if required.
– Work standard/
patient classification
to remain in place to
be utilized by Home
staff to maintain
standards at minimal
ongoing cost.
“The benefits received
by our client in terms of
reduced operating costs,
improved cost effectiveness,
and operations improvement have invariably outweighed the costs for our
services. The benefit to cost
ratio from our assignments
has varied from 3 to 1 to as
much as 30 to 1 or higher.”
Standardcare
Maintain contact with
Carson Manor management staff.
1. Review operational
statistics.
2. Analyze organizational and operating
procedures.
3. Review and assess
level of service in
each section.
4. Identify problems
and potential
improvements.
5. Develop staffing schedules for
comparison against
existing and cost
effectiveness.
6. Identify problems in
respect to physical
environment.
7. Provide draft report.
8. Assess availability
of skills required to
implement.
9. Prepare final
report and
recommendation.
10. Assist with implementation if required.
“With respect to savings,
it is difficult to make
a definitive statement
without having actually completed the study.
However, based on
previous experience, it
is expected that savings
should be in the order
of 8 to10 percent of
total expenses, which
would be approximately
$1.1 million in the case
of Carson Manor.
(Continued)
joh77899_ch06_135-164.indd 163
6/9/10 9:40 PM
164 Purchasing and Supply Management
EXHIBIT 4 Proposals for Carson Manor Review (Continued)
Patientcare
Clarke-Hamilton
Standardcare
3. Experience
– Functional programming
and operations at 11
institutions.
– List of five (5) other
consulting projects.
– All appear large in scope.
– Manage nursing homes
and chronic hospitals.
– Own or lease many other
facilities.
– Operational reviews in
11 institutions—mainly
hospitals with three
regional centers.
– Extensive experience
in specific areas again,
mainly in hospitals.
– Experience in implementing two different types
of work standard/patient
classification systems and
MIS systems.
– Extensive management
consulting experience.
– Appear to have extensive background in
similar situations.
– Extensive list of 15 facilities either completed
or in process.
– Manage Henford
Lodge—150-bed restorative care program.
– Operational review of
Martin Nursing Home.
– Owns or manages
2,400 nursing home
bed and units in this
state and Florida.
4. References
Church Nursing Home,
Dexter
– Could not locate in
Dexter or surrounding
area.
Littlefield Municipal
Hospital, Marsland,
Saskatchewan
– Spoke to administration who advised they
consulted on construction of an addition to the
hospital. Review only of
size, layout, and facilities
required. No operational
or management review
undertaken.
Judd Park Nursing Home
Expansion, Detroit
– Could find no home operating under the name
in Detroit or surrounding
area.
*All other references were
either impractical to contact or were areas currently
owned.
Department of Community
and Social Services
– Firm conducted operational review at Webster
Regional Centre and they
were satisfied with their
performance. Although
not totally implemented,
it appeared that they
would meet or surpass
their estimated savings.
Webster Regional Centre
Mgt.
– Talked to administrator
who was satisfied with
the manner in which they
conducted their review.
Very professional approach with minimum of
disruptions.
Regional Municipality of
Gast City. Greenfield Home
for the Aged
– Firm performed salary
review.
Ward Home for the Aged
– Firm completed
operational review
and currently involved
in implementation.
Particular emphasis on
restorative care techniques in nursing dept.
Certain operations
being contracted out.
Project uncompleted;
however, appears
they will meet their
projected savings of
$280,000.
*Due to high cost of
service, no further references were checked.
joh77899_ch06_135-164.indd 164
6/9/10 9:40 PM
Chapter Seven
Quality
Chapter Outline
Role of Quality in Supply Management
Defining Quality
Quality
Function
Suitability
Reliability
Quality Dimensions
“Best Buy”
Determining the “Best Buy”
The Cost of Quality
Prevention Costs
Appraisal Costs
Internal Failure Costs
External Failure Costs
Morale Costs
An Overall Quality–Cost Perspective
Quality Management Tools and
Techniques
Total Quality Management (TQM)
Continuous Improvement
Quality Function Deployment (QFD)
Six Sigma
Statistical Process Control (SPC)
Sampling, Inspection, and Testing
The Quality Assurance and Quality Control
Group
Assuring the Quality of Purchased Services
Supplier Certification
Quality Standards and Awards Programs
ISO 9000 Quality Standards
ISO 14000 Environmental Standards
The Malcolm Baldrige National (U.S.)
Quality Award
The Deming Prize
Conclusion
Questions for Review and Discussion
References
Cases
7–1 The Power Line Poles
7–2 Air Quality Systems, Inc.
165
joh77899_ch07_165-197.indd 165
6/9/10 9:43 PM
166 Purchasing and Supply Management
Key Questions for the Supply Decision Maker
Should we
• Initiate a total quality management program?
• Initiate a six-sigma program?
• Certify suppliers?
How can we
• Improve customer satisfaction with quality?
• Reduce the costs of quality?
• Improve the measurement of quality of services?
Quality, quantity, delivery, price, and service are the five most common supply requirements. In this chapter on quality, two key questions are addressed: (1) How do we assure
quality? and (2) How do we know that what we ordered meets expectations?
Quality is an area where corporate strategy and our supply network become key influencers. When it comes to quality of output, there are three choices: (1) better than our competitors, (2) the same quality as our competitors, and (3) lower quality than our competitors
(see Figure 7–1). All three are legitimate market niches for goods or services, but they are
different and require different approaches to quality in acquisition.
If an organization competes on quality in its marketplaces, then the supply network or
external supply chain and the internal supply chain have to be able to provide competitive
advantage and differentiation.
This chapter deals with the tools and techniques used to decide what constitutes good
value given the customers’ needs and what the market can supply.
ROLE OF QUALITY IN SUPPLY MANAGEMENT
Quality has always been a major concern in supply management. The traditional definition
of quality meant conformance to specifications. In the total quality management context,
the definition was enlarged to represent a combination of corporate philosophy and quality tools directed toward satisfying customer needs. Even in its simplest definition, quality
FIGURE 7–1
Quality
Market Niches
for Quality
Better Than
Competitors
joh77899_ch07_165-197.indd 166
Same as
Competitors
Lower Than
Competitors
6/9/10 9:43 PM
Chapter 7
Quality
167
continues to represent significant challenges; in its broader context, it may well determine
an organization’s ability to survive and prosper in the years ahead.
While material requirements planning (MRP), manufacturing resource planning
(MRP II), and just-in-time (JIT) (or lean production) have revolutionized the quantity, delivery, and inventory aspects of materials management, they have also required a new
attitude toward quality. When no safety stock is available and required items arrive just
before use, their quality must be fully acceptable. This extra pressure, along with all other
good reasons for insisting on good quality, has sparked major efforts by purchasers to seek
supplier quality assurance. In many cases these efforts have involved supplier certification
programs or partnerships, including the establishment of satisfactory quality control programs at the premises of those who supply the suppliers.
As the service sector grows in size and importance in many economies, the special
challenges of defining, measuring, and assuring quality of services are an even bigger
concern to supply managers. The challenges include adapting and applying quality tools
such as lean thinking to service operations; certifying or partnering with service providers
such as marketing and media companies, law firms, and consultancies; and managing supplier relationships as more and different services are outsourced and moved offshore. The
inclusion of services spend under the umbrella of the purchasing and supply management
organization puts additional pressure on these groups to develop the knowledge and skill
sets of people, and adopt processes and technology appropriate to services.
The interest in quality has reinforced the need for a team buying approach, the trend to
supplier rationalization, data transparency and accessibility, cooperative buyer–supplier
relations, longer-term contracts, contingency planning, and a reevaluation of the role of
the price—quality trade-off in purchase decisions. To understand the role of quality in
procurement, it is necessary to determine what constitutes a “best buy,” and what actions
purchasers might take to ensure that the right quality is supplied.
The quality concept argues that an organization’s products or services are inseparable
from the processes used to produce them. Just focusing on the product or service without
examining the process that produces it is likely to miss the key to continuous improvement. If the process is not in statistical control and targeted for continuous improvement,
the quality of the products produced is likely to suffer. Likewise, if the process for service
delivery is not efficient and effective and targeted for continuous improvement, the quality
of the delivered services is likely to suffer.
Actually, every organization can be seen as part of a chain of organizations that has
suppliers to one side and customers to the other. In further detail, every organization, by
definition, performs three roles: customer, converter, and supplier (see Figure 7–2). As a
converter, every organization needs to add value as its part of the chain or network.
The same idea can be applied on a micro level inside every organization. Each department or function itself is part of an internal chain performing the same three roles: customer, converter, and supplier to other internal functions, and, in some cases, to external
customers and suppliers. Here also, the value-added concept is important. Each department
or function must add value and strive to minimize the cost of doing so by process control
and continuous improvement in congruence with organizational goals and strategies. If a
focus on key business processes has blurred the lines among traditional functions such as
supply, production, and sales, then the cross-functional team must assume responsibility
for quality.
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FIGURE 7–2
Customer
Supplier
The
Transformation
and ValueAdded Chain
Supplier
Converter
Customer
Converter
Customer
Supplier
Converter
DEFINING QUALITY
Practitioners often use the term quality to describe the notions of function, suitability, reliability and conformance with specifications, satisfaction with actual performance, and best
buy. This is highly confusing. The definitions of these terms are discussed below.
Quality
Quality, in the simplest sense, refers to the ability of the supplier to provide goods and
services in conformance with specifications. Quality also may refer to whether the item
performs in actual use to the expectations of the original requisitioner, regardless of conformance with specifications. Thus, it is often said an item is “no good” or of “bad quality”
when it fails in use, even though the original requisition or specification may be at fault.
The ideal, of course, is achieved when all inputs acquired pass this use test satisfactorily.
Function
Function refers to the action(s) that an item or service is designed to perform.
Suitability
Suitability refers to the ability of a material, good, or service to meet the intended functional use. In a pure sense, suitability ignores the commercial considerations and refers to
fitness for use. In reality, that is hardly practiced. Gold may be a better electrical conductor
than silver or copper but is far too expensive to use in all but special applications. That is
why chips are wired with gold and houses with copper. The notion of “best buy” puts quality, reliability, and suitability into a sound procurement perspective.
Reliability
Reliability is the mathematical probability that a product will function for a stipulated
period of time. Complexity is the enemy of reliability because of the multiplicative effect
of probabilities of failure of components. If failures occur randomly, testing is flexible because the same inference may be drawn from 20 parts tested for 50 hours as for 500 parts
tested for two hours. Exceptions like the Weibull distribution (which accounts for the aging
effect) and the bathtub curve (which recognizes the high probability of early failure, a period of steady state, and a higher probability of failure near the end of the useful life) also
can be handled but require more complex mathematical treatment.
From a procurement standpoint, it is useful to recognize the varying reliabilities of components and products acquired. Penalties or premiums may be assessed for variation from
design standard depending on the expected reliability impact.
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Quality Dimensions
Considerable interest in the use of quality as a competitive tool has reawakened management appreciation of the contribution that quality can make in an organization.
On the supply side, how well suppliers perform may be crucial to the buying organization’s own success in providing quality goods and services. A variety of surveys show
that, in many organizations, at least 50 percent of the quality problems stem from
goods and services supplied by suppliers. Moreover, management tools and techniques
such as lean production, MRP, JIT, and stockless purchasing all require that what is
delivered by a supplier conform to specifications. Furthermore, it is not realistic to
insist that suppliers supply quality goods without ensuring that the buying organization’s own quality performance is beyond reproach. This applies to the procurement
organization, its people, policies, systems, and procedures as well. Quality improvement is a continuing challenge for both buyer and seller. Moreover, close cooperation
between buying and selling organizations is necessary to achieve significant improvement over time.
Quality is a complex term, which, according to Professor David Garvin of the Harvard
Business School, has at least eight dimensions:
1.
2.
3.
4.
5.
6.
7.
8.
Performance. The primary function of the product or service.
Features. The bells and whistles.
Reliability. The probability of failure within a specified time period.
Durability. The life expectancy.
Conformance. The meeting of specifications.
Serviceability. The maintainability and ease of fixing.
Aesthetics. The look, smell, feel, and sound.
Perceived quality. The image in the eyes of the customer.
From a procurement point of view, the ninth dimension should be “procurability”—the
short- and long-term availability on the market at reasonable prices and subject to continuing improvement.
“Best Buy”
The decision on what to buy involves more than balancing various technical considerations. The most desirable technical feature or suitability for a given use, once determined,
is not necessarily the desirable buy. The distinction is between technical considerations
that are matters of dimension, design, chemical or physical properties, and the like, and the
more inclusive concept of the “best buy.” The “best buy” assumes, of necessity, a certain
minimum measure of suitability but considers ultimate customer needs, cost and procurability, transportation, and disposal as well.
If the cost is prohibitive, a somewhat less suitable item may have to suffice. Or if, at
whatever cost or however procurable, the only available suppliers of the technically perfect item lack adequate productive capacity or financial strength, then, too, something else
must be used. Also, frequent reappraisals are necessary. If the price of copper increases
from $0.70 a pound to $1.50 or more, its relationship to aluminum or other substitutes
may change.
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The “best buy” is a combination of characteristics, not merely one. The specific combination finally decided on is almost always a compromise, since the particular aspect
of quality to be stressed in any individual case depends largely on circumstances. In
some instances, the primary consideration is reliability; questions of immediate cost
or facility of installation or the ease of making repairs are all secondary. In other instances, the lifetime of the item is not so important; efficiency in operation becomes
more significant.
The decision on what constitutes the best buy for any particular need is as much conditioned by marketing as by procurement and technical considerations. To reach a sound
decision on the best buy requires all relevant parties—marketing, engineering, operations, and supply—to work closely together. The ability and willingness of all parties concerned to view the trade-offs in perspective will significantly influence the final decisions
reached.
Determining the “Best Buy”
It is generally accepted that the final verdict on technical suitability for a particular use
should rest with those involved in using, engineering, specifying, or resale. Supply’s right
to audit, question, and suggest must be recognized along with the need for early involvement of procurement during the design phase.
To meet its responsibility, supply must insist that economic and procurement factors be considered and share its suggestions with those immediately responsible for
specification. The purchaser is in a key position to present the latest information from
the marketplace that may permit modifications in design, more flexibility in specifications, or changes in manufacturing methods that will improve value for the ultimate
customer. Cross-functional teams are preferable to an adversarial approach to “best buy”
determinations.
THE COST OF QUALITY
Prior to the 1950s, the quality–cost curve was thought to be similar to the economic order
quantity curve, or broadly U-shaped (see Figure 7–3). Under this notion, it was considered
acceptable to live with a significant defect level, because it was assumed that fewer defects
would increase costs.
Thanks to the contribution of leaders like Deming, Juran, Shingo, and Crosby,
a new perspective on quality and its achievability emerged. According to this view of
quality, every defect is expensive, and prevention or avoidance of defects lowers costs
(see Figure 7–4).
Interestingly enough, it used to be that purchasers were willing to pay more for higherquality products or services, recognizing the benefits to the purchaser’s organization, but
also assuming that the supplier might have to incur higher costs to achieve better quality.
If quality were “inspected in,” this would indeed be a higher-cost solution. Deming argued
that the stress in quality should be in making it right the first time, rather than inspecting
quality in. Making it right the first time should be a lower-cost solution. Therefore, it is
reasonable for a purchaser and seller to work together on achieving both improved quality
and lower costs!
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FIGURE 7–3
Cost
The
Traditional
View of the
Quality–Cost
Trade-off
0
High prevention cost
High detection cost
Low correction cost
Quality
171
High correction cost
Low prevention cost
Low detection cost
% of
defects
Q opt.
Quality
FIGURE 7–4
The Current
View of the
Quality–Cost
Trade-off
High correction
costs
Cost
Basic prevention and identification costs
0
% of defects
Quality
Many supply policies and procedures have been designed on the principle that competition is at the heart of the buyer–seller relationship. What keeps the seller focused is the fear
that another supplier might take away sales by offering better quality, better price, better
delivery, or better service. The assumption was that a supplier switch was inexpensive
for the purchaser and that multiple sourcing gave the purchaser both supply security and
control over suppliers.
The emergence of quality as a prime supply criterion challenges this competitive view.
It argues that it is very difficult to find a high-quality supplier and even more difficult to
create a supplier who will continually improve quality. In fact, it may require extensive
work of various experts in the supply organization, along with the appropriate counterparts
in the selling organization, to achieve continuing improvement in quality. Under these
circumstances, it is not realistic to use multiple sources for the same end item, to switch
suppliers frequently, and to go out for quotes constantly.
Single sourcing often causes considerable purchaser nervousness. The idea of sharing
key organizational information with suppliers so that they can better plan, design, and
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service the purchaser’s requirements is alarming for procurement experts whose skills were
honed on a competitiveness philosophy. The heart of a new approach to quality centers on
the appropriate use of the hard tools, techniques, and mathematics of quality along with
the soft tools of relationship building. It is important for supply professionals to determine
when a cooperative approach with suppliers is preferable to a competitive one.
Perhaps the older view of quality stems from an economic environment of high demand
and low worldwide competition in which defects were tolerated. Perhaps this was further
abetted by an incomplete grasp of the real costs of quality and of poor quality. Unfortunately, in many organizations, these costs are well hidden and, therefore, difficult to consider in decision making.
Five major cost categories applicable to quality are prevention, appraisal, internal failure, external failure, and morale.
Prevention Costs
Prevention costs relate to all activities that eliminate the occurrence of future defects.
These include such diverse costs as various quality assurance programs; precertifying and
qualifying suppliers; employee training and awareness programs; machine, tool, material,
and labor checkouts; preventive maintenance; and single sourcing with quality suppliers,
as well as the associated personnel, travel, equipment, and space costs.
Appraisal Costs
Appraisal costs represent the costs of inspection, testing, measuring, and other activities
designed to ensure conformance of the product or service. Appraisal costs might occur at
both the seller’s and buyer’s organizations as each uses a variety of inspection systems to
ensure quality conformance. If appraisal requires setting aside batches, or sending product
to a separate inspection department, detection costs should include, aside from the inspection cost itself, extra handling and inventory tie-up costs in terms of space, people, equipment, materials, and associated reporting systems. The advantages of using the supplier’s
quality control (QC) reports and making it right the first time are evident.
Internal Failure Costs
Internal failure costs are the costs incurred within the operating system as a result of
poor quality. Included in internal failure costs are returns to suppliers, scrap and rework,
lost labor, order delay costs including penalties, machine and time management, and all
costs associated with expediting replacement materials or parts or the carrying of extra
safety stock.
External Failure Costs
External failure costs are incurred when poor-quality goods or services are passed on to
the customer and include costs of returns, warranty costs, and management time handling
customer complaints. Unfortunately, when poor-quality parts are incorporated in assemblies, disassembly and reassembly costs may far outweigh the cost of the original part
itself. When a defective product gets into the hands of customers or their customers, the
possibility of consequential damages arises because a paper roll did not meet specifications, the printer missed an important deadline, a magazine did not reach advertisers and
subscribers on time, and so on. There may be health or safety consequences from defective
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products. These costs are the most expensive because of the possible effects on individual
customer goodwill and lost sales and profits. The loss of customers, the inability to secure
new customers, and the penalties paid to keep existing customers are also part of external
failure costs.
Morale Costs
One cost seldom recognized in an accounting sense is the morale cost of producing (or
having to use) defective products or services. Aside from the obvious productivity impact, it may remove pride in one’s work or the incentive to keep searching for continuing
improvement. The motivation to work hard and well may be replaced by a “don’t care”
attitude.
An Overall Quality–Cost Perspective
It is so unpleasant to detail the costs of defective quality that the temptation is strong
to ignore them. And that is exactly what many organizations have done for many years.
They also have built these costs into internally accepted standards. As a consequence, the
opportunity to improve quality is great in most organizations.
Some organizations have attempted to quantify the total cost of quality, and the outcome
of such studies suggests that 30 to 40 percent of final product cost may be attributable to
quality. Obviously, there is a huge incentive to tackle quality as a major organizational
challenge. For example, Kodak’s cost of quality model is used to quantify, in dollars, quality performance of suppliers by looking at defects per part per million (DPPM), delivery,
lead times, administrative costs of corrective actions, and potential line down situations.
The model may also be used in benchmarking suppliers in e-auctions and on sourcing
activities.1
QUALITY MANAGEMENT TOOLS AND TECHNIQUES
The question of how to assure quality is important for all three roles played by an organization: customer, converter, or supplier of goods or services. This section addresses tools and
techniques for assuring quality, including total quality management (TQM); continuous
improvement or kaizen: quality function deployment (QFD); six sigma; statistical process
control (SPC); sampling; inspection, and testing; and supplier certification.
Total Quality Management (TQM)
Total quality management (TQM) is a philosophy and system of management focused
on long-term success through customer satisfaction. It was developed in Japan after
W. Edwards Deming taught statistical quality control to the Union of Japanese Scientists
and Engineers (JUSE) in 1950. Total quality control (TQC) was reimported to the United
States in the 1980s and contributed to the revitalization of US industries. It is known internationally as total quality management (TQM).
In a TQM effort, all members of an organization participate in improving processes,
products, services, and the culture in which they work. Top management develops the vision for total quality and provides the commitment and support, including progress reviews,
1
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Source: Major Elements of the SQP Process, http://www.qfdi.org/what_is_qfd/what_is_qfd.html.
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174 Purchasing and Supply Management
to realize this vision. The customer can be internal or external and is anyone in the supply
chain who receives materials from a previous step in the chain. The methods for implementing this approach come from the teachings of such quality leaders as Philip B. Crosby,
W. Edwards Deming, Armand V. Feigenbaum, Kaoru Ishikawa, and Joseph M. Juran.
Deming’s 14 Points
A core concept in implementing TQM is Deming’s 14 points, a set of management practices to help companies increase their quality and productivity. These are:2
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
Create constancy of purpose for improving products and services.
Adopt the new philosophy.
Cease dependence on inspection to achieve quality.
End the practice of awarding business on price alone; instead, minimize total cost by
working with a single supplier.
Improve constantly and forever every process for planning, production, and service.
Institute training on the job.
Adopt and institute leadership.
Drive out fear.
Break down barriers between staff areas.
Eliminate slogans, exhortations, and targets for the workforce.
Eliminate numerical quotas for the workforce and numerical goals for management.
Remove barriers that rob people of pride of workmanship, and eliminate the annual
rating or merit system.
Institute a vigorous program of education and self-improvement for everyone.
Put everybody in the company to work accomplishing the transformation.
From this list, four important features of TQM emerge:
1. Quality must be integrated throughout the organization’s activities.
2. There must be employee commitment to continuous improvement.
3. The goal of customer satisfaction, and the systematic and continuous research process
related to customer satisfaction, drives TQM systems.
4. Suppliers are partners in the TQM process.
TQM stresses quality as the integrating force in the organization. For TQM to work, all
stages in the production process must conform to specifications that are driven by the needs
and wants of the end customer. All processes, those of the buyer and the suppliers, must be
in control and possess minimal variation to reduce time and expense of inspection. This in
turn reduces scrap and rework, increases productivity, and reduces total cost. TQM is more
than a philosophy. It involves the use of several tools, such as continuous improvement
or kaizen, quality function deployment (QFD), and statistical process control to achieve
performance improvements.
The following sections describe how quality management techniques are used and how
they apply to the supply function.
2
http://www.asq.org/learn-about-quality/total-quality-management/overview/overview.html
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Continuous Improvement
Continuous improvement, sometimes called by its Japanese name, kaizen, refers to the relentless pursuit of product and process improvement through a series of small, progressive
steps. It is an integral part of both just-in-time (JIT) and TQM. Continuous improvement
should follow a well-defined and structured approach and incorporate problem-solving
tools such as Pareto analysis, histograms, scatter diagrams, check sheets, fishbone diagrams, control charts, run charts, and process flow diagrams.
The plan–do–check–act cycle, sometimes called the Deming Wheel, provides a good
model for conducting continuous improvement activities.
Plan: Collect data and set performance target.
Do: Implement countermeasures.
Check: Measure and evaluate the results of countermeasures.
Act: Standardize and apply improvement to other parts of the organization.
Honda’s BP Program is an example of applying a continuous improvement philosophy
to supplier management. BP stands for best position, best productivity, best product, best
price, and best partners. The BP is a 13-week process that focuses on waste elimination.
It is based on the principle that the people who perform the work are the greatest source
of improvement ideas and creativity. Like all Honda improvement initiatives, BP follows
Deming’s plan–do–check–act cycle.3
Quality Function Deployment (QFD)
Quality function deployment (QFD) is an important aspect of TQM. It is a method for
developing higher-quality new products at less cost and in less time. It has been used successfully by Toyota and many others.
QFD is a comprehensive quality design method that
• Seeks both spoken and unspoken customer needs.
• Identifies positive quality and business opportunities.
• Translates these into actions and designs by using transparent analytic and prioritization
methods.
• Empowers organizations to exceed normal expectations.
• Provides a level of unanticipated excitement that generates value.
The QFD method can be used for both tangible products and nontangible services across
business sectors.4
QFD is based on teamwork and customer involvement. It integrates marketing, design,
engineering development, manufacturing, production, and supply in new product development from the conception stage through final delivery. Through coordination and integration,
rather than the traditional sequential development approach, QFD allows the end customer’s
needs and wants to be communicated at the product development stage and then drive the
design and production stages. More time is spent up front in product development, but by
3
4
joh77899_ch07_165-197.indd 175
Dave Nelson, Rick Mayo, and Patricia Moody, Powered by Honda (New York: John Wiley & Sons, 1998).
Source: QFD Institute, http://www.qfdi.org/what_is_qfd/what_is_qfd.htm.
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accurately defining customer needs and wants, the total time spent on the design cycle is
reduced because fewer design changes are made in later stages of the process.
The four integrated stages of the QFD process are:
1.
2.
3.
4.
Product planning, to determine design requirements.
Parts deployment, to determine parts characteristics.
Process planning, to determine manufacturing requirements.
Production planning, to determine production requirements.
Buyer and supplier integration into the process can benefit the organization by:
1.
2.
3.
4.
5.
Reducing or eliminating engineering changes during product development.
Reducing product development cycle time.
Reducing start-up cycle time.
Minimizing product failures and repair costs over the product life.
Creating product uniformity and reliability during production.
From the perspective of supply management, well-functioning buyer–supplier relationships are a key contribution that purchasers and supply managers can make to the
organizations’ TQM and QFD efforts. Supply-base rationalization and closer relationships with key suppliers through partnering arrangements or strategic alliances go hand
in hand with quality initiatives (see Chapter 13). The importance of matching supply
performance measures to the strategic initiatives of the organization is also important
if TQM and QFD are to be successful. For example, if supply’s performance is measured by a reduction in the prices of materials and improved operating efficiency rather
than the quality of supplier relationships, then purchasers may buy on the basis of price
alone. This will undermine the quality initiatives of the firm. Integration of functions and
processes throughout the firm, and with key suppliers, is a critical component of global
competitiveness.
Six Sigma
A Six Sigma (6) approach to quality focuses on preventing defects by using data to reduce variation and waste. This quality initiative was developed by GE and Motorola and
has been adopted by many organizations. Six Sigma quality means there are no more than
3.4 defects per million opportunities. Technically, 6 or six standard deviations are very
close to zero defects and correspond to a Cpk value (discussed later in this chapter) of
2.0. Six Sigma initiatives have measurable goals such as cost reduction or profit increase
through improvements in cycle time, delivery, safety, and so on.
According to Benbow and Kubiak writing for the ASQ, Six Sigma is defined in several ways:
1. It is a philosophy based on the view that all work is processes that can be defined, measured, analyzed, improved, and controlled. Processes require inputs (x) and produce
outputs (y). If you control the inputs, you will control the outputs.
2. It is a set of tools, including statistical process control (SPC), control charts, failure
mode and effects analysis, and flowcharting. These are qualitative and quantitative
techniques to drive process improvement.
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3. It is a methodology with five steps: define, measure, analyze, improve, and control
(DMAIC). This is the most widely adopted and recognized six sigma methodology.5
The common elements of Six Sigma initiatives are:
• A management environment that supports the initiatives as business strategy. Organizational support is provided by designated executives and champions who set the direction
for project selection and deployment.
• Well-defined projects with bottom-line impact.
• Teams whose members have statistical training. Levels include black belt, master black,
green, yellow, and white belts. Each level has specific roles and project responsibilities.
• Emphasis on the DMAIC approach.
Statistical Process Control (SPC)
Dr. W. Edwards Deming, the well-known American quality control specialist, assisted Japanese manufacturers in instituting statistical quality control (SQC) beginning in the 1950s.
Dr. Deming showed that most processes tend to behave in a statistical manner and that understanding how the process behaves without operator interference is necessary before controls
can be instituted. Managing quality using SQC techniques involves sampling processes and
using the data and statistical analysis to establish performance criteria and monitor processes.
Statistical process control (SPC) is a technique that involves testing a random sample of
output from a process in order to detect if nonrandom, assignable changes in the process are
occurring. Because almost all output results from a manufacturing or transformation process of some sort, process control is the preferred approach to controlling product quality.
The first step in quality assurance is making sure that the supplier’s process capability
and the buyer’s acceptable quality range mesh. If the natural range of the supplier’s process
is wider than the range of the buyer’s quality requirements, then the buyer must negotiate
with the supplier to have the supplier narrow the natural range through process improvements such as operator training or machine improvements. If it is not economically feasible
or the supplier is unable or unwilling to make improvements for some reason, then the buyer
may seek another supplier rather than incur the extra cost of inspection, rework, and scrap.
From the buyer’s perspective, the basic steps in assuring quality through statistical process control are:
1. Buyer establishes required quality specifications.
2. Supplier determines process capability.
a. Identify common or chance causes of variation.
b. Identify special or assignable causes of variation.
c. Eliminate special causes.
3. Compare buyer’s quality requirements to supplier’s process capability.
4. Make adjustments, if necessary.
a. Negotiate with supplier for process improvements.
b. Seek an alternate supplier.
5
Donald W. Benbow and T. M. Kubiak, The Certified Six Sigma Blackbelt Handbook (ASQ Quality Press,
2005, pp. 1–2).
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Causes of Variation
Since no process can produce the same exact results each time the activity is performed,
it is important to establish what kind of variation is occurring and eliminate as much as
possible. A process capability study identifies two types of variation: (1) common causes
or random variation and (2) special or assignable causes of variation.
Common or chance causes of variation. These causes are intrinsic to the process and
will always be there unless the process is changed. They may be related to machine, people,
material, method, environment, or measurement. For instance, machine lubrication, tool
wear, or operator technique would be common causes that result in inconsistent output.
If too many defects occur because of common causes, then the process must be changed.
Special or assignable causes of variation. These causes are outside, nonrandom problems such as breakdown of machinery, material variation, or human error. These must be
identified and eliminated. Otherwise, the output will fall outside the acceptable quality
range. Statistical process control procedures are primarily concerned with detecting and
eliminating assignable or special causes.
Process capability
A process is capable when there are no special or assignable causes of variation, only common or chance causes. It is capable of meeting specifications consistently. The process is
said to be in statistical control or stable and predictable. If a process is capable, then the
probability of a process meeting customer specifications can be predicted. The process
averages a set number of standard deviations within the specifications.
In determining whether or not a process is stable, the supplier must determine what
the natural capability of the process is and whether or not the upper and lower capability
limits meet the specifications of the buyer. When a process is “in control,” the supplier can
predict the future distributions about the mean. For a process to be capable and in control,
all the special causes of variation in output have been eliminated, and the variation from
common causes has been reduced to a level that falls within the acceptable quality range
specified by the buyer.
Design engineers establish the upper and lower specification limits based on a specific
design function.
Upper specification limit (USL). The USL is the maximum acceptable level of output.
Lower specification limit (LSL). The LSL is the minimum acceptable level of output.
The USL and the LSL are related to a specific product specification; they are independent
of any process. The allowable difference between a physical feature and its intended design
is the tolerance. For example, design engineering writes a specification for a rod to have a
diameter of 2 inches with a tolerance of .005 inches. The LSL is 1.995 inches, and the
USL is 2.005 inches. Any rods produced within this range are within tolerance.
Process Capability Index (Cp). This index combines process spread and tolerance into
one index and indicates whether process variation is satisfactory. The higher the Cp, the
more capable the process is of producing parts that are consistently within specification.
This index assumes the process is centered between the USL and the LSL and that processes are 6 sigma wide, representing 99.7 percent of the output of a normal process.
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A process with a Cp of less than 1.0 is generally considered not capable. If the capability
index is greater than 1.0 the process is capable of producing 99.7 percent of parts within
tolerance. The Cp is calculated as:
USL LSL
Cp 6
For example, if the tolerance is 2.000 inches ± .0005 inches and the standard deviation of
the process () was .0016 inch.
2.005 1.995
Cp 1.04
6 .0016
A Cp of 1.33 has become a standard of process capability. Purchasers can specify process
capability expectations. Some organizations require a higher value of 2.0. A higher value
means fewer defects and greater quality.
Cpk Index. This index adjusts the Cp for the effect of noncentered distribution. Cpk is
defined as the lower of either of the following:
__
Upper tolerance limit X
Process spread
__
or
X
Lower tolerance limit
Process spread
__
X is the process mean, and the process spread is equal to three standard deviations of the
output values, or the spread on one side of the process average. A process with a Cpk of
1. Less than 1.0—unacceptable because part of the process distribution is out of
specification.
2. Between 1 and 1.33 marginal because the process distribution is barely within
specification.
3. Greater than 1.33 acceptable because the process distribution is well within the
specification.
Process Control
Process control is a key aspect of TQM. It is a method of monitoring a process to prevent
defects. Both the center and the variation around the center are measured. Quality control
charts are the primary tool.
Quality control charts. In processes using repetitive operations, the quality control chart
__
is invaluable. The output can be measured by tracking a mean and dispersion. The (X )
chart is useful for charting the population means and the R chart the dispersion.
Upper and lower control limits. Upper (UCL) and lower (LCL) control limits can be set
so that operator action is required only when the process or machine starts to fall outside of
its normal desirable operating range. The UCL represents an upward shift of 3 from
the mean value of a variable. The LCL represents a similar downward shift. For a normally
distributed output, 99.7 percent should fall between the UCL and the LCL. The process is
stable as long as output falls within the established limits.
Figure 7–5 illustrates this “wandering” type of behavior at a steel mill. The rolling
operation controls the thickness of the steel. Each hour the operator collects thickness
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FIGURE 7–5
Control Chart
Control Chart
0.034
0.033
0.032
UCL
0.031
LCL
Sample
0.030
Average
0.029
0.028
0.027
1
2
3
4
5
6
7
8
9
10
Sample Number
data and enters on the chart the means of samples taken from the process. An R chart is
the plot of the range within each of the samples. If the mean or range falls outside its acceptable limits, the process is stopped. Action is then taken to determine the cause for the
shift so that corrections can be made.
The control chart uses random sampling techniques (discussed in the next section). It is
well suited to most manufacturing and service operations producing large output where it is
not necessary to screen every item produced: for example, stamping steel parts or processing applications in an insurance office.
Sampling, Inspection, and Testing
As discussed earlier in this chapter, each organization is a customer, a converter, and a
supplier. Therefore, there are three opportunities for each organization to experience poor
quality: as a supplier whose goods or services fail to meet customers’ quality specifications,
as a converter whose process fails to produce to customers’ quality specifications, and as a
customer who receives goods or services that fail to meet its quality specifications.
The high cost of correcting poor-quality products and services drives the focus on building in quality rather than inspecting it after production or delivery. Building it right the first
time is the primary goal of the quality management programs discussed in this chapter.
Managing the costs of quality is also an important part of the quality management process.
Decisions about sampling, testing, and inspection drive costs into the process and ultimately into the final product or service. These decisions are cost-benefit decisions wherein
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the goal is to balance the cost of sampling, testing, and inspection against the risk of either
accepting a lot with more than an acceptable level of defects or of rejecting a good lot.
Lowering either risk requires a larger sample size, and this leads to higher costs.
Sampling, testing, and inspection are quality management tools that may be used at
three different stages in the acquisition process.
1. Before a purchase commitment is made to a supplier. It may be necessary to test
samples to see if they are adequate for the intended purpose. Similarly, comparison
testing may be done to determine which product is better from several different sources.
Also, historical quality control data may be used in the supplier evaluation process to
determine a supplier’s quality capability relative to the buyer’s quality specifications.
2. During the commitment to a supplier. Sampling or inspection is performed to ensure
that the conversion process is in control and that defects are minimal.
3. After a purchase commitment has been made. Inspection may be required to ensure
that the items delivered conform to the original description.
There are basically two major types of quality checks on tangible output. One is sampling and the other is 100 percent inspection or screening.
Sampling
A sample is a small number of items selected from a larger group or population of items.
The goal is to secure a sample that is representative of the total population being tested.
The results of testing or inspecting the sample are used to accept or reject the entire batch
or lot. How a sample is taken will vary with the product and process. Random sampling is
one commonly used technique.
Random Sampling. A random sample is one in which every element in the population
has an equal chance of being selected. The method of taking a random sample will depend
on the characteristics of the product to be inspected. If all products received in a shipment
can be thoroughly mixed together, then the selection of a sample from any part of the total
of the mixed products will represent a valid random sample. For example, if a shipment
of 1,000 balls of supposedly identical characteristics is thoroughly mixed together and a
random sample of 50 balls is picked from the lot and inspected and five are found to be
defective, it is probable that 10 percent of the shipment is defective.
If the product has characteristics that make it difficult or impractical to mix together
thoroughly, then consecutive numbers can be assigned to each product, and tables or computer programs of random numbers can be used to draw a sample for detailed inspection.
The general rule of statisticians when drawing a random sample is: Adopt a method of
selection that will give every unit of the product to be inspected an equal chance of being
drawn.
Sequential Sampling. Sequential sampling may be used to reduce the number of items
inspected in accept–reject decisions without loss of accuracy. It is based on the cumulative
effect of information that every additional item in the sample adds as it is inspected. After
each individual item’s inspection, three decisions are possible: accept, reject, or sample
another item. A. Wald, one of the pioneers of sequential sampling development, estimated
that, using his plan, the average sample size could be reduced to one-half, as compared to
a single sampling plan.
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In a simple version of sequential sampling, 10 percent of the lot is inspected, and the
whole lot is accepted if the sample is acceptable. If the sample is not acceptable, an additional 10 percent may be inspected if the decision to reject cannot be made on the basis of
the first sample. These methods reduce the cost of quality.
100 Percent Inspection or Screening
It is often held that 100 percent inspection, or screening, is the most desirable inspection method
available. This is not true. Experience shows that 100 percent inspection seldom accomplishes
a completely satisfactory job of separating the acceptable from the nonacceptable or measuring
the variables properly. Actually, 200 or 300 percent inspection or even higher may have to be
done to accomplish this objective.
Depending on the severity of a mistake, an error of discarding a perfectly good part may be
more acceptable than passing a faulty part. In some applications, the use of such extreme
testing may increase the cost of a part enormously. For example, in certain high-technology
applications, individual parts must be accompanied by their own individual test “pedigrees.” Thus, a part that for a commercial application might cost $0.75 may well end up
costing $50.00 or more and perform the identical function.
One of the many contributions of Shigeo Shingo in Japan was the development of foolproof, simple “poka yoke” devices that permit inexpensive, rapid 100 percent inspection to
ensure zero defects. A simple example is the three-prong power cable connector that can
only be inserted in the proper manner.
Testing
Testing products may be necessary before a commitment is made to purchase. The original
selection of a given item may be based on either a specific test or a preliminary trial.
When suppliers offer samples for testing, the general rule followed by purchasers is
to accept only samples that have some reasonable chance of being used. Buyers are more
likely to accept samples than to reject them, since they are always on the lookout for items
that may prove superior to those in current use. For various reasons, however, care has to be
exercised. The samples cost the seller something and the buyer will not wish to raise false
hopes on the part of the salesperson. Sometimes, too, the buyer lacks adequate facilities for
testing or testing may be costly to the buyer. To meet these objections, some organizations
insist on paying for all samples accepted for testing, partly because they believe that a more
representative sample is obtained when it is purchased through the ordinary trade channels
and partly because the buyer is less likely to feel under any obligation to the seller. Some
organizations pay for the sample only when the value is substantial; some follow the rule
of allowing whoever initiates the test to pay for the item tested; some pay for it only when
the outcome of the test is satisfactory. The general rule, however, is for sellers to pay for
samples on the theory that, if sellers really want the business and have confidence in their
products, they will be willing to bear the expense of providing free samples.
Use and Laboratory Tests. The type of test varies, depending on such factors as the
attitude of the buyer toward the value of specific types of tests, the type of item in question,
its comparative importance, and the buyer’s facilities for testing.
A use test alone may be considered sufficient, as with paint and floor wax. One advantage of a use test is that the item can be tested for the particular purpose for which it is
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intended and under the particular conditions in which it will be used. However, there is a
risk that failure may be costly or interrupt performance.
A laboratory test alone may be adequate and may be conducted by a commercial testing
laboratory or in the organization’s own quality control facility. For retailers, a test may be
given in one or more stores to establish whether consumer demand is sufficient to carry
the product.
Commercial Testing Labs and Services. The type of inspection required may be so
complicated or expensive that it cannot be performed satisfactorily in the buyer’s or seller’s own organization. The services of commercial testing laboratories may be used, particularly for new processes or materials or for aid in setting specifications. Also, the use
of an unbiased testing organization may lend credibility to the results. For example, air,
water, and soil samples are often sent to commercial labs to test for compliance with EPA
standards.
Furthermore, standard testing reports of commonly used items are available from several commercial testing laboratories. They are the commercial equivalent of consumer’s
reports and can be a valuable aid.
The actual procedure for handling samples need not be outlined here. It is important
to make and keep complete records concerning each individual sample accepted. These
records should describe the type of test, the conditions under which it was given, the results, and any representations made about it by the seller. It is sound practice to discuss
the results of such tests with supplier representatives so that they know their samples have
received a fair evaluation.
Inspection upon Receipt
The ideal situation is one in which no receiving inspection is necessary because the joint
buyer–supplier quality assurance effort has resulted in outstanding quality performance
with reliable supplier-generated records. However, not all organizations have reached this
enviable goal. The type of inspection, its frequency, and its thoroughness vary with circumstances. In the final analysis, this is a matter of comparative costs. How much must be
spent to ensure compliance with specifications?
The purpose of inspection upon receipt is to assure the buyer that the supplier has delivered an item that corresponds to the description furnished. Receiving inspection may
be used initially for products or services of new suppliers. If quality is consistently within
specification, then the level of inspection may decrease. Unfortunately, production or service delivery methods and skills, even of established suppliers, change from time to time;
operators or service providers become careless; errors are made; and occasionally a seller
may try to reduce production costs to the point where quality suffers. Good supply policy
may lead to an increase in inspection while cause and remedy are determined. While the
goal is to eliminate the need for inspection by building in quality, inspection is used in
some situations.
In setting specifications, it is desirable to include the procedure for inspection and testing as protection for both buyer and seller. The supplier cannot refuse to accept rejected
goods on the ground that the type of inspection to which the goods would be subjected was
not known or that the inspection was unduly rigid. Supplier and purchaser need to work
out both the procedure for sampling and the nature of the test to be conducted. This way
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both supplier and purchaser should achieve identical test results, no matter which party
conducts the test. Whereas in some situations purchasers may be more sophisticated in
quality control and, in others, the suppliers are more sophisticated, it is sensible for both
sides to cooperate on this issue.
Adjustments and Returns
The supply department, aided by the using, inspection, or legal department, is responsible
for prompt action on adjustments and returns. Any nonconforming product, material, or
equipment must be secured to avoid the possibility of inadvertent processing, pilferage,
or additional damage while its disposition is being deliberated. Some organizations use a
material review board to decide how to deal with specific nonconforming materials.
The actual decision about what can or should be done with material that does not meet
specifications is both an engineering and a procurement question. Nonconforming material
can be rejected and returned at the supplier’s expense or held for disposition instructions.
In either case, the buyer must inform the supplier if the shipment is to be replaced with acceptable material or if other alternatives are being considered. Frequently a material may be
used for another purpose or substituted for some other grade. One alternative is to rework
the material and deduct the additional processing cost from the purchase price. Also, the
supplier may send a technical representative to the buyer’s organization to provide complete
satisfaction, particularly in the case of new types of equipment or new material.
The costs incurred when materials are rejected may be divided into three major classes:
(1) transportation costs, (2) testing cost, and (3) contingent expense. The buyer and seller
must decide how to allocate these costs between them. This is partially affected by the kind
of material rejected, trade customs, the essential economies of the situation, the buyer’s
cost accounting procedure, and the positions of strength of each organization. Typically,
transportation costs both to and from the rejection point are charged back to the supplier.
Inspection or testing costs are ordinarily borne by the buyer and are considered a part of
purchasing or inspection costs.
Contracts or trade customs often provide that the supplier will not be responsible for
contingent expense. This is, however, perhaps the greatest risk and the most costly item
of all from the buyer’s standpoint. Incoming materials that are not of proper quality may
seriously interrupt production; their rejection may cause a shortage of supply that may
result in customer penalties, delay or actual stoppage of production, extra handling, and
other expense. Labor and/or equipment time may be expended in good faith on material
later found to be unusable. It is, in general, however, not the practice of buyers to allocate
such contingent costs to the supplier. Some buyers, however, insist on agreements with
their suppliers to recover labor, equipment, or other costs expended on the material before
discovery of its defective character.
The frequency of defective materials or services decreases drastically when there is a
buyer–supplier partnership or a joint quality program. The resolution of difficulties from
defective or late deliveries is usually handled in a highly professional and efficient manner,
avoiding the nastiness of blame, avoidance, and litigation threats.
The Quality Assurance and Quality Control Group
The primary responsibilities of a quality assurance and quality control department or
function are to establish and maintain effective controls for monitoring processes and
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equipment and supporting efforts to help suppliers and their suppliers to design, implement, and monitor continuous quality improvement programs. Additionally, their responsibilities include the technical task of inspecting incoming material or monitoring in-house
production. The group also plays a key role in supplier certification; initiates materials
studies; and inspects samples provided by suppliers. Frequently it must investigate claims
and errors, related both to incoming items and to outgoing or finished products. It may
examine material returned to stores to determine its suitability for reissue. Similarly, it
may be called on to examine salvage material and to make a recommendation about its
disposition.
The structure and location of the quality assurance function constitute a relevant problem of administration. In most cases, the work of inspection is performed by a separate
department whose work may be divided into three main parts: the inspection of incoming
materials, the inspection of materials in the process of manufacture, and the inspection of
the finished product. The assignment of this work to a separate department is supported
partly on the ground that if the inspectors of materials in process and of the finished product
report to the executive in charge of operations, there may be occasions when inspection
standards are relaxed in order to cover up defects in production. In some organizations, the
quality assurance function reports to the supply manager.
Many quality control software programs are available. They have resolved the tedium
of extensive calculations and charts and provide a range of applications. Standard programs, for example, select sampling plans, calculate sample statistics and plot histograms,
produce random selection of parts, plot operating characteristics (OC) curves, and determine confidence limits.
Assuring the Quality of Purchased Services
As addressed in Chapter 6, “Need Identification,” services fall along a continuum of highly
tangible to highly intangible, and intangibles cannot be inventoried. These two aspects of
service can create special quality measurement difficulties.
In highly tangible services such as construction, quality control can be geared heavily
toward the measurement of the tangible, in ways similar to standard quality assurance and control. However, all aspects of the ability of the actual service provider(s)
(people) to consistently perform the service at the desired quality level are vital to the
performance evaluation process. This means the quality of the intangibles must also be
assessed. Intangibles such as “Were the supplier’s personnel sufficiently courteous when
dealing with the purchaser’s employees?” may be measured by a survey or by number
of complaints received. But it is important to recognize that any standard, at best, will
be imprecise.
Because the nature of many services prevents storage, delivery tends to be instantaneous. In other words, quality control will have to be performed while the service delivery
is in progress, or afterward. And it may be difficult to interrupt the process, even if simultaneous quality control is possible. Therefore, the quality risk in services may be relatively
high compared to the purchase of products. In cases of quality failure, it may not be possible to return the services for a full refund.
Postservice evaluation is an essential component in effective service acquisition. The
same checklist that was used in sourcing may also be used for postservice evaluation.
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Informal Evaluation
At the very least, an informal evaluation might suffice. In the case of consulting services,
this might include two questions:
1. Did your problem or issue get resolved to your satisfaction?
2. Would you rehire this consultant in the future for another problem or issue?
Additional questions regarding conformance to expectations of quality, timeliness, and
cost are appropriate, as well as feedback on the professionalism and service orientation of
the consultant personnel.
Quality risk avoidance may be achieved by certifying service providers, doing business with
service suppliers found to be satisfactory in the past, avoiding repeat business with suppliers
who did not do a good job, carefully checking suppliers beforehand with other users with similar needs, and using carefully worded preservice delivery communications with the supplier
and service users to ensure common understanding of requirements and expectations.
Formal Evaluation
A formal service quality evaluation process developed by Parasuraman, Zeithaml, and
Berry identifies five quality dimensions:
Reliability: ability to perform the promised service dependably and accurately.
Responsiveness: willingness to help customers and provide prompt service.
Assurance: knowledge and courtesy of employees and their ability to inspire trust and
confidence.
Empathy: caring, individualized attention the firm provides its customers.
Tangibles: physical facilities, equipment, and appearance of personnel.6
The survey process measures the gap between service expectations along each dimension and the perceptions of actual service performance.
Ultimately, the goal of effective acquisition of services is to obtain best value. In this
sense there is no difference between the acquisition of services and goods. And the best
buy in services represents the appropriate trade-off between quality, quantity, delivery,
price/cost, and other relevant factors. In the assessment of quality of purchased services, the
following characteristics might be considered: value, repetitiveness, tangibility, direction, production, nature of demand, nature of delivery, degree of customization, and the skills required
for producing the service. Each of these will be discussed in turn.
Value of the Service
One broad cut at services would be to classify services as high, medium, or low value. This
could be done in the typical ABC/Pareto analysis or portfolio analysis that looks at both
value and risk to acquire. ABC classification would focus quality attention on high-spend
services. Portfolio analysis would focus more quality attention on services with potential
high impact on the organization. For example, the improper removal of asbestos from a
6
A. Parasuraman, V. A. Zeithaml, and L. L. Berry, “A Conceptual Model of Service Quality and its Implications for the Future,” Journal of Marketing, Fall 1985, pp. 41–50; and SERVQUAL: A Multiple-Item Scale
for Measuring Consumer Perceptions of Service Quality,” Journal of Retailing, Spring 1988, pp. 12–40.
Their two references likely were the first presentations of this approach.
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building may make the whole building unusable. A consultant to assist in the long-term
strategic planning of the organization may have a very significant, long-term impact. Quality assurance and quality control efforts might be organized according to classification.
Degree of Repetitiveness
For the acquisition of repetitive services, it may be possible to develop a standard quality assessment tool and gather quality information on a regular basis. The quality of unique service
requirements may be more difficult because the quality is assessed as the service is delivered.
Electronic sourcing tools that are used to acquire repetitive services that are easily standardized and low risk to acquire may also be used to collect quality feedback from users.
Degree of Tangibility
By definition, every service tends to have an intangible dimension, such as the conviviality
dimension in the hospitality industry. Even so, some services can be seen as more tangible
than others. For example, an architect will produce a drawing or a design that can be examined by others and that ultimately will result in a physical structure. Although the structural
features of the physical representation of the design can be examined for quality purposes,
the aesthetic features of the design are much more difficult to evaluate and subject to a wide
variety of responses.
On the other hand, the advice from a consultant on a new marketing strategy may be
almost totally intangible. The development of quality standards in any contract for services
is obviously difficult. For services where there is no accompanying good, qualifications
for the people or equipment providing the service may be used as quality markers. For
example, the number of personnel in the organization who have appropriate training in the
particular discipline, and the capability of the various pieces of equipment, can be specified
ahead of time and measured against in the quality assessment. Unfortunately, many segments of the service sector are plagued by high personnel turnover, and the addition or loss
of a few key people can make a significant difference in the quality provided.
Expressions of levels of satisfaction or dissatisfaction by various users or experts may be
used. For example, how many complaints are received about the cleanliness of the building?
Or how many experts believe the software program to be acceptable? It should be recognized
that the selection of experts or evaluators represents a statistical quality problem. Some people
may be more eager than others to express their opinions, and their views may not be representative of the whole group. Relying solely on complaints may give a biased response.
Direction of the Service
Another aspect of service deals with whether or not it is directed at people. For example, food
services are for people; maintenance services may be for buildings or equipment. When services are directed at people, it is important to recognize the special needs of the persons who
will be most affected by the service. The ultimate user likely will play a major role in both
the specification of the service and the assessment of quality received. If services directed at
people have an important intangible component, assessment may require a period of exposure
of both supplier and purchaser personnel to each other to determine compatibility.
Production of the Service
Services can be produced by people or equipment, or a combination of both. Services of
low labor intensity may have a high capital or asset component. Typical examples would
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include real estate and equipment rentals, computer processing, transportation, and communication services, as well as custom processing of a machine-intensive nature. In the
specification stage, understanding the underlying technology or asset base is important
partly because it drives the quality delivered. During the acquisition stage, potential suppliers can be assessed on the basis of their asset capacity and availability as well as the
state of their technology. These factors then become part of the quality assessment. The
delivery of this kind of service is more likely at the location of the supplier’s premises or of
its equipment, although hookup may be directly to the purchaser’s site. Quality monitoring
and evaluation may be process oriented, with emphasis on the performance of the underlying capital asset.
Services with high labor intensity include activities like hand harvesting, installation
and maintenance, education, health support, and security, as well as the full range of professional activities like consulting, engineering, accounting, medical, and architectural services. Here the quality of the “people component” is the primary concern.
Services involving largely lower- to medium-skilled people may focus more on cost
minimization and efficiency. Services requiring highly skilled individuals may require the
purchaser to distinguish between levels of professional skill and may require extensive
ongoing communication between requisitioner and supply manager through all phases of
the acquisition process to accurately assess quality delivered.
Nature of the Demand
The demand for a particular service may be continuous, periodic, or discrete.
The typical example of a continuous service may be insurance or a 24-hour, aroundthe-clock security service. Periodic service may be regular, such as once a week or once a
month, as with regular inspections, or it may vary with need, as in repair services. It may
be possible to monitor the quality of a continuous or periodic service and make alterations
as information about the quality of service becomes evident. However, this may be
more difficult if the person(s) actually providing the service are different each time the
service is provided. Some of this type of variation may be reduced by specifying the actual
people who will perform a service and requiring that no personnel changes can be made
without prior approval.
A discrete or one-shot service may be the acquisition of an interior decorator to suggest
a new color scheme for an office complex. The quality monitoring capability may have
to be shifted to the various stages in the delivery process, if this is possible. The problem
may be that by the time the service is delivered, it is too late to make significant quality
improvements.
Nature of Service Delivery
The nature and place of service delivery may have significant acquisition repercussions.
For example, if the delivery of the service occurs on the premises of the purchaser, the
contract agreement may have to address a number of provisions. For example, in construction or installation services, questions of security; access; nature of dress; hours of work;
applicability of various codes for health, security, and safety; what working days and hours
are applicable; and what equipment and materials are to be provided by whom are all issues
that need to be addressed as part of the contract. It is vital to determine which issues are
related to the quality of the service and how to write these terms clearly.
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On the other hand, when the service is provided on the supplier’s premises or elsewhere,
many of these concerns may not arise, provided the service is not directed at personnel of
the purchaser.
Degree of Standardization
It makes a substantial difference whether a service is standard or customized specifically
for the purchaser. Generally speaking, the less the consumer contact, the more standard
the service becomes, and, probably, the less the importance of intangibles. Quality assessments may be easier because suppliers can be prequalified or certified and a standard type
of supplier evaluation exists.
With highly customized services, the specification process may become more difficult and the options more difficult to understand. The involvement of the end consumers in this specification process then becomes more important. The acquisition process
itself may be less definite, since various suppliers may offer substantially different options. Evaluation of supplier performance may have to recognize the purchaser’s share
of responsibility for quality at the point of delivery.
Skills Required for the Service
The production of a service may require a full range of skills, from unskilled on the one
extreme to highly skilled on the other. In services requiring relatively unskilled labor, such
as grass cutting and other simple maintenance tasks, price emphasis is likely to be high and
ease of entry into (and exit from) the service also may be high. Quality may be monitored
primarily through user feedback.
As discussed earlier, the acquisition of highly skilled services may focus far more on
qualifications of the skilled persons, concern over the specific persons who will be performing the service, and recommendations from other skilled persons and users. Frequently, in
highly professional services, the cost of the professional service may be relatively low
compared to the benefit expected. For example, a good design may increase sales substantially; a good architect may be able to design a low-cost, but effective structure; and a good
consulting recommendation may turn around a whole organization. It often is difficult to
deal with this trade-off between the estimated costs for the job and the estimated benefits.
If the buyer wants to link outcome to quality, then there must be some means of assessing
cause and effect to determine if high (or low) quality was due to the services provided by
the service provider or actions within the buying organization.
Supplier Certification
Supplier certification is a process of evaluating and recognizing the quality performance
of an organization’s suppliers. Standards are established for quality, and often delivery
and productivity performance as well. Suppliers that consistently meet these standards are
certified. Suppliers benefit from systematic improvements that may increase their profitability; they typically are considered first for new business; and they are often publically
recognized by the buying organization. Buying organizations benefit by consistently receiving required quality and delivery levels and enjoying systematic improvements over
time. Continuing involvement with suppliers may lead to common quality standards and
agreement on inspection methods and ways of improving quality while decreasing inspection and overall cost.
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Purchasers often conduct a quality capability or quality assurance survey on the supplier’s premises either before a new supplier is given an order or before a supplier is allowed to quote. This is to ensure that the supplier is capable of meeting the specifications
and quality standards required. The practice is common in many types of organizations
including high-technology areas and most larger organizations.
The survey is normally conducted by relevant departments such as engineering, manufacturing, supply, and quality control personnel for goods or user group, purchasing, and
quality control for services. It examines the supplier’s equipment, facilities, and personnel
as well as quality control systems and processes. The supplier’s supply chain management
initiatives are also examined. These include the supplier’s efforts to seek cooperation and
compliance in quality standards from its suppliers and the supplier’s commitment to ongoing quality improvement.
The decision to purchase only from certified suppliers extends beyond quality considerations. In organizations pursuing partnerships with suppliers, quality certification is usually
the first category of interorganizational alignment. In many industries, a minimum level of
quality capability is a standard requirement for any supplier and corporate survival may
depend on it.
The quality target is to have the right quality by making it right the first time, rather
than inspecting in quality. It is this pressure to create quality at its source that is behind
all quality improvement programs. The same philosophy also should apply to the supply
department itself and the purchaser’s own organization. It is very difficult for a purchaser
to insist that suppliers meet stringent quality requirements when it is obvious to the
suppliers that the supply organization itself shows no sign of a similar commitment. Any
supply department wishing to start a quality drive may want to apply quality standards to
its own performance on all of the phases in the acquisition cycle. Not only will this create
familiarity with statistical quality control and quality standards in the supply department
itself, but it also gives supply the right to ask for similar commitment by others.
QUALITY STANDARDS AND AWARDS PROGRAMS
At the international level, the International Organization for Standardization (ISO) runs several quality-related programs. Organizations in various countries also offer quality awards.
The following are discussed in this section: ISO 9000 Quality Standards, ISO 14000 Environmental Standards, The U.S. Malcolm Baldrige Award, and the Japanese Deming Award.
ISO 9000 Quality Standards7
The International Organization for Standardization (ISO) in Geneva, Switzerland, provides common standards across the world. The American National Standards Institute
(ANSI) and the Canadian Standards Association (CSA) are North American members.
The ISO 9000 quality standards, which were first adopted in 1987 and revised in 1994 and
2000, are now being transitioned to ISO 9001:2008.
7
Source: Information about the International National Standards Organization can be found on their
Web site at www.iso.ch
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Quality
191
According to the ISO, the ISO 9000 family of standards represents an international
consensus on good quality management practices. It consists of standards and guidelines
relating to quality management systems and related supporting standards.
ISO 9001:2008 is the standard that provides a set of standardized requirements for a
quality management system, regardless of what the user organization does, its size, or
whether it is in the private or public sector. It is the only standard in the family against
which organizations can be certified—although certification is not a compulsory requirement of the standard. It provides a tested framework for a systematic approach to managing
organizational processes to consistently deliver product that satisfies customers’ expectations. It defines the requirements a quality system must meet, but does not dictate how they
should be met in any specific organization. This leaves scope and flexibility for implementation in different business sectors and business cultures, as well as in different national
cultures.
The other standards in the family cover specific aspects such as fundamentals and
vocabulary, performance improvements, documentation, training, and financial and economic aspects.
Checking That It Works
1. The standard requires the organization itself to audit its ISO 9001:2008––based quality
system to verify that it is managing its processes effectively, or, to put it another way,
to check that it is fully in control of its activities.
2. In addition, the organization may invite its clients to audit the quality system in order to
give them confidence that the organization is capable of delivering products or services
that will meet their requirements.
3. Lastly, the organization may engage the services of an independent quality system certification body to obtain an ISO 9001:2008 certificate of conformity. This last option
has proved extremely popular in the marketplace because of the perceived credibility
of an independent assessment.
The organization may thus avoid multiple audits by its clients or reduce the frequency
or duration of client audits. The certificate can also serve as a business reference between
the organization and potential clients, especially when supplier and client are new to each
other, or far removed geographically, as in an export context.
ISO 14000 Environmental Standards8
ISO 14000, similar to ISO 9000 in management principles, focuses on environmental
issues. ISO 14000 standards describe the basic elements of an effective environmental management system (EMS) and do not replace federal, state, and provincial environmental laws
and regulations.
The ISO 14000 series consists of two standards related to EMS. ISO 14004:2004
provides guidelines on the elements of an environmental management system and its
implementation and discusses principal issues involved. ISO 14001:2004 specifies the
requirements for such an environmental management system. Fulfilling these requirements
8
joh77899_ch07_165-197.indd 191
ISO 9000 Essentials, http://www.iso.org/iso/iso_9000_essentials
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192 Purchasing and Supply Management
demands objective evidence that can be audited to demonstrate that the environmental
management system is operating effectively in conformity to the standard.
The Malcolm Baldrige National (U.S.) Quality Award
The annual Malcolm Baldrige National Quality Award is intended to recognize U.S.
organizations in business, health care, education, and nonprofit. The award recognizes
excellence in quality achievement and quality management. The criteria are designed to
help organizations enhance their competitiveness by focusing on two goals: delivering
ever-improving value to customers and improving overall organizational performance. It
is also designed to motivate U.S. companies to improve quality and productivity, provide
standardized quality guidelines and criteria for evaluating quality improvement efforts,
and provide guidance to U.S. organizations striving to make improvements by describing
how winning organizations were able to achieve their successes. The diffusion of TQM
practices is one of the most important aspects of the Baldrige Award, and the organization
sends out more than 200,000 criteria packages each year.
The Baldrige Award evaluates both quality management programs and achievement of
results, with heavy emphasis on total corporate financial performance. Some companies, such
as Honeywell, Motorola, Southwest Bell, and Cummins Engine, have required their suppliers
to use modified versions of the Baldrige criteria for quality measurement and evaluation.
The Deming Prize
To commemorate Dr. Deming’s contribution and friendship and to promote the continued
development of quality control in Japan, the Union of Japanese Scientists and Engineers
(JUSE) created the Deming prize. Established in 1950, it is given annually. The Deming
Prize for Individuals is open only to Japanese candidates. However, the Deming Application Prize, the Quality Control Award for Operations Business Units, and the Japan Quality
Medal are open to overseas companies. For example, Tata Steel Limited, India, won The
Deming Application Prize in 2008 and The Siam White Cement Company, Ltd., Thailand,
was a co-winner with Niigata Diamond Electric Company, Ltd., Japan in 2009. The Deming
Prize carries a tremendous amount of international prestige.
Similar prizes are awarded in Canada and other countries.
Conclusion
joh77899_ch07_165-197.indd 192
Quality is one of the essential requirements for supply along with quantity, delivery, price,
and service. The continuous pursuit of zero defects over many decades has evolved an impressive array of quality diagnostic and improvement tools. Making it right the first time
rather than inspecting quality in is the prevailing wisdom.
Service goes beyond the essential tangible support a supplier is expected to provide
such as installation of a new piece of equipment; most purchasers see service also as
intangible—reflecting responsiveness, flexibility, willingness to provide assistance in case
of emergency, evidence of concern for continuous improvement, and friendliness. Thus,
service is more difficult to specify, but very real in actual supplier–purchaser dealings. It
is easy to promise and difficult to obtain. Both high quality and service form the basis for
a longer-term successful relationship between a buyer and a seller and for supply chain
cooperation and effectiveness.
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Quality
193
Questions
for
Review
and
Discussion
1. Why should a purchaser be familiar with the mathematics of quality control and
inspection?
2. Why use supplier certification?
3. How does the degree of tangibility of a service influence quality assessment?
4. How could a quality philosophy be applied to a supply department?
5. What are the various costs associated with quality, and why is it difficult to determine
the magnitude of some of these costs?
6. Why was Deming so insistent on single sourcing?
7. What does it mean if a supplier is ISO 9000 certified? ISO 14000 certified?
8. What are the trade-offs between 100 percent inspection and sampling?
9. What constitutes a best buy?
10. What are some of the aspects of quality assurance when buying services?
References
American National Standards Institute, www.ansi.org.
Askin, R. G., and J. B. Goldberg. Design and Analysis of Lean Production Systems. New
York: Wiley, 2002.
Benbow, D. W., and T. M. Kubiak, The Certified Six Sigma Black Belt Handbook. ASQ
Quality Press, 2005.
Besterfield, D. H. Quality Control. 8th ed. Upper Saddle River, NJ: Prentice-Hall, 2008.
Bounds, G. Cases in Quality. Burr Ridge, IL: Irwin, 1996.
Choi, T. Y., and M. Rungtusanatham. “Comparison of Quality Management Practices:
Across the Supply Chain and Industries.” Journal of Supply Chain Management, Winter
1999, pp. 20–27.
International Standards Organization, www.iso.org.
Juran, J. M., and J. A. De Feo. Juran’s Quality Handbook: The Complete Guide to
Performance Excellence. 6th ed. New York: McGraw Hill, 2010.
Leenders, M. R., and P. F. Johnson. Major Structural Changes in Supply Organizations.
Tempe, AZ: Center for Advanced Purchasing Studies, 2000.
Nelson, D.; R. Mayo; and P. Moody. Powered by Honda. New York: John Wiley &
Sons, 1998.
Prahalad, C. K., and M. S. Krichman. “The New Meaning of Quality in the Information
Age.” Harvard Business Review, September–October 1999, pp. 109–118.
Ritzman, L. P.; L. J. Krajewski; and M. K. Malhotra. Operations Management. 9th ed.
Toronto: Pearson Prentice Hall, 2010.
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194 Purchasing and Supply Management
Case 7–1
The Power Line Poles
experience gained on this first section would guide the
contracts on the remaining half. Mr. Yarrow had to
ensure a start on the 345 KV line by the fall. This left
not much time in which to develop pole prototypes and
to perform the engineering tests in advance of erection. The number of potential suppliers was limited by
two major requirements. Each supplier had to have a
design computer program and a large press-brake for
heavy metal.
Moren Corporation was building three additional powergenerating stations to serve the rapidly expanding energy
market. To link these stations to the existing area grid, a
new method of carrying the power lines using ornamental
tubular poles, instead of towers, had been adopted. The
second phase of the project involved pole manufacture
to a functional engineering design with parameters.
Mr. Gordon Yarrow, supervisor of materials purchasing,
wondered how to deal with the exceptions to the contract
terms quoted by Henry Nelson Company, the preferred
pole supplier.
FIRST PROGRESS REPORT
In May, having received bids from eight potential suppliers, Gordon Yarrow was able to give his superior a brief
rundown on his progress. He told Mr. Carter he had encountered quite a spread in prices and that there were disturbing gaps in engineering information in some cases,
but he believed the timetable could be met.
Mr. Yarrow went over all detailed information and
prices in the following weeks with Mr. Northrup, Moren’s
senior transmission project engineering, and together they
rejected four bidders. (See Exhibit 1 for the remaining
quotes).
At the request of Mr. Northrup, Gordon next sent
engineering information only (no prices) on the four
remaining bidders to Moren’s engineering consultants
for a complete analysis of the bids on the basis of the
requested design, a comparison of designs furnished, and
BIDDING PROCEDURES—
PRESELECTION
Gordon Yarrow had the responsibility to recommend
a pole manufacturer. Gordon had the consulting
engineers’ services and the experience of his own
engineering department to assist him. The consulting
engineering firm on the project had been selected in
August, and by early spring of the following year it
had furnished Moren with functional specifications for
the poles, cross arms, and hardware. Moren engineers
recommended that the quotations should first be
obtained on the most pressing portion of the line linking
Addison to Smithfield. This amounted to about half of
the total project distance. The expectation was that the
EXHIBIT 1 Quotation Summary—Poles and Arms 345 KV Line Addison-Smithfield Section
Bidders
Molson, Inc.
Bid (in $000)
Extra for base
Escalation
Total
M
N
O
P
Norris Steel Co.
$22,400
1,400
252
$24,052
Structures Cdn., Ltd.
$24,160
—
Firm
$24,160
Henry Nelson Co.
$24,640
—
Firm
$24,640
Jordan Pole Co.
$27,896
—
500
$28,396
Quantity: 390 type 3A, 61 type 3B, 24 type 3C, 7 type 3D, 8 type 3E. Total 490
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Chapter 7
exceptions to specifications. Mr. Northrup agreed to meet
with bidders M, N, and P to resolve the engineering and
fabricating capabilities of each. This was not necessary
for bidder O (Henry Nelson Company) because he was
already working for Moren.
In mid-June Mr. Northrup called Gordon Yarrow to
share his findings. He said, “I have serious reservations
about three bidders, M, N, and P based on equipment,
plant capacity, and ability to meet our deadlines. Our consultants agree.”
Based on engineering and fabricating experience, our
first recommendation is Nelson. I will confirm this in
writing. However, these exceptions to our specifications
Quality
195
would still have to be resolved. I will leave these to you to
work out and Mr. Northrup handed a sheet of comments
to Gordon Yarrow (See Exhibit 2).
NELSON’S EXCEPTIONS
After his visit with Mr. Northrup, Gordon Yarrow returned to his office and examined Nelson’s quotation.
Not knowing whether Nelson would be recommended by
the engineers, he had not paid much attention to Nelson’s
exceptions to Moren’s bid requirements. There were six
exceptions noted on Mr. Northrup’s summary. Gordon
wondered how he should tackle them.
EXHIBIT 2 Comments on the Exceptions to Specifications in Nelson Company’s BID
Exception 1
The exception to the method of shipping would relieve Nelson of the responsibility for poles during
shipment from the southern factory to your storage yards.
Exception 2
In Nelson’s bid, no material could be rejected on the basis of low Charpy values shown on the mill test
reports or by sampling on anything but the thickest plate of the heat. Similarly, welding materials or
techniques would not be subject to rejection because of low Charpy results, which is inconsistent with the
intent of the specifications.
Exception 3
Excessive bolt projections represent a hazard to installation and maintenance personnel and would also
increase construction costs.
Exceptions 4 and 5
Under Nelson Company’s proposed Welding and Inspection Specifications, the purchaser would be
prohibited from using radiography to determine weld quality, even for the purpose of clarifying the
interpretations of ultrasonic indications or for use where ultrasonic inspection cannot be made. Only visual
or magnetic particle inspection would be permissible for any welds except the pole shaft to base plate weld
and the longitudinal welds at the lap joints. Some welds, such as the arm to butt plate welds, are virtually
impossible to adequately inspect after they are completed and require inspection while the work is being
performed; most inspection techniques except radiography are of questionable value following galvanizing;
all inspection would have to be made in the fabricator’s plant. Henry Nelson Company’s proposed
inspection procedures are less stringent than AWS-D1.0.69 in allowing 3/16” or smaller defects regardless
of spacing.
Exception 6
Nelson’s Conditions of Sale give the purchaser only five days from unloading to make claims for damaged
or defective material. The warranty clause is unclear in that it can be interpreted to mean that Nelson has
one year in which to make corrections but no provision for correcting defective material unless found in the
five-day inspection period. It is our understanding that the intent is to provide a one-year warranty but the
words do not so state.
Escalation Clause
Delays in delivery that are not caused by the purchaser should not be charged to the purchaser.
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196 Purchasing and Supply Management
Case 7–2
Air Quality Systems, Inc.
Patrick Wallace, plant manager at Air Quality Systems
Inc. (AQS), in Richmond, Virginia, found himself confronted with a serious quality problem on the company’s
main product line. The foam insulation for a batch of heat
recovery ventilation products manufactured at the plant
had begun to peel off, making it likely that the equipment
would malfunction. To make matters worse, Patrick also
believed that it was likely that defective equipment had
already been shipped to customers. It was Wednesday,
August 6, and Patrick knew that he had to react immediately to the problem.
THE COMPANY
Since the company’s founding in 1984, AQS was committed to its mission to enhance the consumer’s quality of
life by creating, manufacturing, and marketing innovative
energy-recovery products. It manufactured ventilation,
air-cleaning, and heating equipment for residential and
light commercial applications and had acquired a reputation in the industry for high quality and technological
innovation.
Company management believed that its strengths
lay in four key areas: design, assembly, steel fabrication, and the manufacture of aluminum heat recovery
ventilators (HRV). AQS occupied a 65,000-square-foot,
state-of-the-art manufacturing plant and was ISO 9001
registered. Facilities included a fully equipped laboratory
and R&D area. Sales had increased consistently and were
expected to reach $12 million in the current year, with
sales of HRVs accounting for approximately two-thirds
of the total.
Approximately 60 percent of the 3,400 parts used by
AQS in its manufacturing operations were procured from
suppliers, while the remaining 40 percent were produced inhouse. Supply of the most critical components were single
sourced, while sourcing decisions for less important commodity or commodity-like items were usually purchased
on the basis of low cost, provided suppliers were able
to meet expectations concerning quantity, delivery, and
quality. Component parts were inspected by operators as
part of their responsibilities in the assembly operations. As
plant manager, Patrick was responsible for quality control
and oversaw a staff of two technicians who handled product testing and addressed customer quality issues.
joh77899_ch07_165-197.indd 196
PRODUCTS AND CUSTOMERS
AQS sold more than 300 different products under the
AirPurity brand name to large distributors. Distributors
sold these products to wholesalers, who in turn sold to independent contractors. Contractors installed the products
in homes and commercial buildings. Large wholesalers
and contractors also could buy products directly from
AQS. Heat recovery ventilators moved stale air from inside the house to outdoors. At the same time, they drew
in fresh air from outside and distributed it throughout the
house or building, thereby replenishing the environment.
As the two airstreams passed on either side of an aluminum heat exchanger, the heat from the outgoing air was
transferred to the incoming air. The efficiency of the AirPurity HRV was such that virtually none of the warmth
collected from the home was lost to the outside. In the
summer, the HRV worked in reverse, removing heat
from the incoming air and transferring it to the outgoing
air. Residential units (with a capacity of 95–300 cubic
feet per minute) were sold to homeowners, while commercial units (with a capacity of 500–2,500 cubic feet per
minute) were sold to owners of large buildings, such as
schools and offices. AQS products also could be used by
homeowners in specific parts of the home, such as indoor
pools and garages. A typical HRV residential unit cost
between $550 and $750.
In addition to selling products under its own brand
name, AQS also manufactured about 20 products for
over a dozen large companies, which in turn sold these
products under their own brand name. These companies
included well-known names such as Honeywell, Lennox,
and Sears.
THE QUALITY PROBLEM
The quality problem centered on the damper door for
HRVs. The damper door was a steel door covered with
foam insulation. The foam insulation consisted of a layer
of PVC, a layer of foam, and a layer of adhesive. Suffolk
Industries (Suffolk), a local manufacturer, supplied this
product to AQS for all of its HRVs. In industry terminology, Suffolk was a “converter.” It bought foam from
a foam manufacturer, cut it into the required shape, and
applied layers of PVC and adhesive to the product. It was
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Chapter 7
placed on the damper door during the assembly operation
at AQS, with the adhesive ensuring that it adhered to the
door. Up until this point, the foam insulation supplied by
Suffolk had proven to be of a reliable quality.
The converter business was not particularly capital
intensive, while foam manufacturing, on the other hand,
was extremely capital intensive. The product specified
by AQS was ether foam, which required high concentrations of fire-retardant chemicals to make it heatresistant to enable it to withstand the high temperatures
used in the converter process. Other kinds of foam did
not usually require high concentrations of fire-retardant
chemicals.
The previous day, one of the operators in the assembly
department noticed that the foam insulation was peeling
off the damper doors in a batch of HRV equipment that
had been manufactured recently and was awaiting shipment to customers. The foam was separating from the
PVC layer, leaving a layer of adhesive on the door.
The separation of the foam insulation was likely to cause
the HRV unit to malfunction. After further investigation, Patrick expected that a similar problem might have
occurred with some product that had already been shipped
joh77899_ch07_165-197.indd 197
Quality
197
to customers, although he could not be sure at this point
how long the quality problem had existed.
FUTURE COURSE OF ACTION
Patrick knew that he needed to act fast to resolve this
problem and wondered about the appropriate course of
action. Although the problem had been identified internally, he had not contacted either Suffolk or any of his
customers. In the meantime, Patrick had stopped all HRV
deliveries until the problem was resolved, although several customers currently waiting for deliveries would be
disappointed about any delays. Hence, Patrick felt that
resolving this matter quickly was paramount.
A further issue related to avoiding similar problems in
the future. The company had expanded quickly over the
past few years, and Patrick wanted to protect the company’s image of producing quality products. He wondered
what, if anything, could be done to proactively avoid similar product-quality problems. Specifically, he wondered
whether he should insource supply of additional components or, alternatively, what changes he might consider
for existing supply relationships.
6/9/10 9:43 PM
Chapter Eight
Quantity and
Inventory
Chapter Outline
Quantity and Timing Issues
Quantity and Delivery
Time-Based Strategies
Forecasting
Forecasting Techniques
Collaborative Planning, Forecasting, and
Replenishment (CPFR)
Determining Order Quantities and
Inventory Levels
Fixed-Quantity Models
Fixed-Period Models
Probabilistic Models and Service Coverage
Buffer or Safety Stocks and Service Levels
Planning Requirements and Resources
Material Requirements Planning (MRP)
Capacity Requirements Planning (CRP)
Manufacturing Resource Planning (MRP II)
Enterprise Resource Planning (ERP)
Systems
Supply Implications of MRP
Inventory Management
Costs of Inventories
ABC Classification
Vendor- or Supplier-Managed Inventory
(VMI/SMI)
Lean Supply, Just-in-Time (JIT), and
Kanban Systems
Managing Supply Chain Inventories
Determining Quantity of Services
Aggregating Demand
Managing Consumption
Dimensions of Services and Quantity
Decisions
Conclusion
Questions for Review and Discussion
References
Cases
8–1 Sedgman Steel
8–2 Throsel-Teskey Drilling
Functions and Forms of Inventories
The Functions of Inventory
The Forms of Inventory
Inventory Function and Form Framework
198
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Quantity and Inventory 199
Key Questions for the Supply Decision Maker
Should we
• Change the way we forecast?
• Use vendor-managed inventories?
• Purchase our A items differently?
How can we
• Reduce our investment in supply chain inventories?
• Improve our inventory management?
• Initiate a services consumption management program?
Continuous improvement; speed to market; customer, employee, and supplier satisfaction;
and global competitiveness require dedication to productivity and value-adding activities.
These organizational goals drive management attitudes to quality, quantity, and delivery,
with profound impact on the acquisition process. This is evident in supply management’s
focus on inventory reduction and shortened lead times. Both can be accomplished by increasing frequency of deliveries, while decreasing the amount delivered at one time. Accompanying efforts in setup time reduction, just-in-time (JIT) systems, vendor-managed inventory
systems (VMI), order cost reduction, electronic data interchange (EDI), and e-commerce are
all part of the same drive.
In many organizations, the decisions of how much to purchase and when are made more
important by the close relationship between purchase quantity and scheduled use. It is
necessary to distinguish between how much to buy in an individual purchase or release and
what portion of total requirements to buy from an individual supplier. This chapter deals
only with individual order quantities and inventory management; the allotment to suppliers
is discussed in Chapters 5, 12, and 13.
Three key questions are addressed in this chapter: (1) How much to acquire? (2) When
to acquire? and (3) How to inventory effectively?
QUANTITY AND TIMING ISSUES
The decisions of how much to acquire and when logically follow clarification of what is
required. The natural response is to say, “Buy as much as you need when you need it.”
Such a simple answer is not sufficient, however. Many factors significantly complicate
these decisions.
1. Forecasts. Managers must make purchase decisions before, often a long time before,
actual requirements are known. Therefore, they must rely on forecasts, not only of future demand, but also of lead times, prices, and other costs. Such forecasts are rarely,
if ever, perfect.
2. Costs. There are costs associated with placing orders, holding inventory, and running
out of materials and goods.
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200 Purchasing and Supply Management
3. Availability. Materials may not be available in the desired quantities without paying a
higher price or delivery charge.
4. Price-Volume Relationship. Suppliers may offer reduced prices for buying larger
quantities.
5. Shortages. Shortages may cause serious disruptions.
Quantity and Delivery
Quantity and delivery go hand in hand. Order less, deliver more frequently; order more,
deliver less frequently. Every supplier performance evaluation scheme includes quantity
and delivery as standard evaluation criteria. To ensure timely delivery, recognition needs
to be given to the times required to complete each of the steps in the acquisition process
discussed in Chapter 4. The ability to compress these times by doing them in parallel, by
eliminating time-consuming and nonvalue-adding activities, by doing steps faster, and by
eliminating delays can provide significant benefits. Much of the reengineering work in
the supply area has focused on the acquisition process to make it more responsive and to
reduce cycle time.
Time-Based Strategies
For the supply management function, the time-based strategies that are of importance in
the quantity decision are ones that relate directly to the flow of materials and services, inventories (raw material, work-in-process, and finished goods), and related information and
decisions. Competitive advantage accrues to organizations that can
1. Successfully reduce the time it takes to perform activities in a process (reduce setup and
cycle time).
2. Coordinate the flow of resources to eliminate waste in the system and ensure that materials and equipment arrive on time or just-in-time in economically sized batches.
Long lead times can occur in the design and development process, in the material acquisition to distribution of finished goods process, and in administrative support cycles (e.g.,
accounts payable, purchase order development/release cycle). Some of the causes of long
lead times are waiting and procrastination, poorly engineered designs, the accumulation of
batches prior to movement, inefficient and long physical flows with backtracking, and poor
communication.
Long lead times can impact decisions about how much to buy. Compressed cycle times
and coordination of material and information flows can result in materials arriving just-ontime (e.g., when they were scheduled to arrive) or just-in-time (just prior to actual use or
need). Material requirements planning–type (MRP) programs or kanban (pull systems) can
be used to plan the timing and quantity of purchased materials and internally manufactured
materials.
There are many causes for poor material flow coordination, including late, early, or
no deliveries; low fill rate; material defects; scrap; uneven batch sizes; long lead times;
production schedule changes; downtime; long setup/changeover times; infrequent updates of MRP systems; forecasts; and on-hand inventory accounting systems. Greater
coordination of material and information flows both within the buying firm and with
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Chapter 8
Quantity and Inventory 201
its customers and between the buying firm and its suppliers (and their suppliers) can
result in lower inventories and improvements in return on assets in the supply chain (see
example in Chapter 1).
FORECASTING
Decisions about how much to order, when to order, and how to inventory effectively are
also complicated by the rapidly changing environment within which order, inventory and
supply planning is carried out. Inventories always seem to be too big, too small, of the
wrong type, or in the wrong place. With changing economic conditions, what is too little in
one period may easily become too much in the next.
Forecasting is very much a part of the supply management picture and directly
affects both quantity and delivery. Forecasts of use, supply, market conditions, technology, price, and so on, are always necessary to make good decisions. The problem
is how to plan to meet the needs of the future, which requires answers to questions
such as:
• Where should the responsibility for forecasting future usage lie?
° Should the supply management group be allowed to second-guess sales, production,
or user forecasts?
° Should other supply chain members be involved in a collaborative forecasting effort?
• If the forecast is wrong, who bears the risks?
° Should suppliers be held responsible for meeting forecasts or actual requirements?
° Should the supply manager be held responsible for meeting forecasts or actual
requirements?
° When should responsibilities for dealing with the results of inaccurate forecasts be
outlined in the contract?
° What role does negotiation play in resolving these issues?
In many organizations, the need for raw materials, services, parts, and subassemblies
is usually derived from a sales forecast, which is the responsibility of marketing. In some
service organizations and public agencies, the supply function often must both make forecasts and acquire items. In resale, the buyer may have to assess the expected sales volume (including volumes at reduced prices for seasonal goods), as well as make purchase
commitments recognizing seasons. Whatever the situation, missed forecasts are quickly
forgotten, but substantial overages or shortages are long remembered. Supply managers
are often blamed for overages or shortages no matter who made the original forecast or
how bad the forecast was.
Forecasting the consumption of services also may be difficult. Often there are numerous consumption points (for example through Web portals or service desks), and
few controls on employee orders. If services spend management is widely dispersed
throughout the organization, there may be multiple contracts with the same suppliers as well as multiple suppliers and different coding systems for the same service.
In these situations, forecasting aggregate demand is difficult. On the selling side,
forecasting service capacity is equally difficult. Many organizations use temporary
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202 Purchasing and Supply Management
labor as a means of mitigating the risks of poor forecasts of the demand for laborintensive services.
The real problem with forecasts is their unreliability. Forecasts will usually be wrong,
but will they exceed or fall short of actual requirements, and by how much? Continuous
improvement methods can be applied to forecasting by tracking forecast accuracy and taking steps to eliminate root causes of forecast error.
To a supplier, a substantial variation from forecast may appear as a procurement ploy.
If demand falls below forecast, the supplier may suspect that the original forecast was an
attempt to obtain a favorable price or other concessions. Should demand exceed forecast,
supplier costs may well increase because of overtime, rush buying, and changed production schedules. Purchasers need to share forecast uncertainty regularly with suppliers so
that their quotations may take uncertainty into account. Such sharing is obviously impossible if buyers themselves are not aware of the uncertainty and its potential impact on the
supplier. Forecasts also should be updated regularly.
Forecasting Techniques
There are many forecasting techniques that have been developed and an extensive literature that describes them. This section will review some briefly but will not describe any
technique in detail.
Quantitative Forecasting
This approach uses past data to predict the future. One class of quantitative forecasting
techniques, causal models, tries to identify leading indicators, from which linear or multiple regression models are developed. A carpet manufacturer might use building permits
issued, mortgage rates, apartment vacancy rates, and so on to predict carpet sales. Standard computer programs are used to develop and test such models. Chosen indicators are
usually believed to cause changes in sales, although even good models do not prove a
cause-and-effect relationship. Indicator figures must be available far enough ahead to give
a forecast that allows sufficient time for managerial decisions.
A second quantitative forecasting class assumes that sales (or other items to be forecast)
follow a repetitive pattern over time. The analyst’s job in such time series forecasting is to
identify the pattern and develop a forecast. The six basic aspects of the pattern are constant
value (the fluctuation of data around a constant mean), trend (systematic increase or decrease in the mean over time), seasonal variations, cyclical variations, random variations,
and turning points. Time series forecasting techniques include simple moving averages,
weighted moving averages, and exponential smoothing.
Qualitative Forecasting
One of the most common classes is the qualitative approach of gathering opinions from a
number of people and using these opinions with a degree of judgment to give a forecast.
Market forecasts developed from the estimates of sales staff, district sales managers, and so
on are an example. Such forecasts may also flow from the top down. The Delphi technique
is a formal approach to such forecasting. Collective opinion forecasts lack the rigor of more
quantitative techniques but are not necessarily any less accurate. Often, knowledgeable
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Chapter 8
Quantity and Inventory 203
people with intimate market knowledge have a “feel” that is hard to define but that gives
good forecasting results.
Collaborative Planning, Forecasting, and Replenishment (CPFR)
CPFR is one example of a business practice in which multiple trading partners agree to
exchange knowledge and share risks to generate the most accurate forecast possible and
develop effective replenishment plans. CPFR links sales and marketing processes to supply chain planning and execution processes. Customers enjoy increased product availability.
Partners benefit from increased sales, reduced inventories and cost, and higher service levels.
Trading partners agree to mutual business objectives and measures, develop joint sales and
operational plans, and electronically collaborate to generate and update sales forecasts and replenishment plans. When changes in demand, promotions, or policy occur, jointly managed
forecasts and plans can be adjusted immediately, minimizing or eliminating costly after-thefact corrections for both parties.
DETERMINING ORDER QUANTITIES AND INVENTORY LEVELS
In the following sections, some relatively simple theoretical models used to determine
order quantities and inventory levels are discussed. The application of these models depends on whether the demand or usage of the inventory is dependent or independent.
• Dependent demand. The item is part of a larger component or product, and its use is
dependent on the production schedule for the larger component. Hence, dependent demand items have a derived demand.
• Independent demand. The usage of the inventory item is not driven by the production
schedule. It is determined directly by customer orders, the arrival of which is independent of production scheduling decisions.
Fixed-Quantity Models
The classic trade-off in determining the lot sizes in which to make or buy cycle inventories
is between the costs of carrying extra inventory and the costs of purchasing or making more
frequently. The objective of the model is to minimize the total annual costs. In the very
simplest form of this model, annual demand (R), lead time (L), price (C ), variable order
or setup cost (S ), and holding cost percentage (K ) are all constant now and in the future.
When inventory drops to the reorder point (P), a fixed economic order quantity (Q) is ordered. Back orders and stockouts are not allowed.
Total cost is given as purchase cost, plus setup or order cost, plus holding cost, or
RS QKC
TC RC 2
Q
Using differential calculus, the minimum value of Q (also known as the EOQ) is found at
____
Qopt joh77899_ch08_198-230.indd 203
兹
2RS
KC
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204 Purchasing and Supply Management
This is the value at which order cost and carrying cost are equal. Figures 8–1 and 8–2 show
how costs vary with changes in order size and how inventory levels change over time using
this model. As an example of the use of the model, consider the following:
R=
C=
K=
S =
annual demand
delivered purchase cost
annual carrying cost percentage
order cost
_____________
____
Qopt 兹
= 900 units
= $45/unit
= 25 percent
= $50/order
2RS
KC
兹
2 900 $50
89 units
.25 $45
FIGURE 8–1
Material
Carrying and
Order Costs
Cost
ing
arry t
al c
s
t
o
T
r co
orde
and
st
g co
yin
r
Car
Ordering cost
EOQ Order Size
FIGURE 8–2
Simple Fixed
Quantity
Model
Inventory
(units)
L
P
EOQ
L = Lead time
EOQ = Order quantity
= Reorder point, P
Time
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Chapter 8
Quantity and Inventory 205
To determine the reorder point P, it is necessary to know the lead time L, which is 10
working days. Assuming 250 working days per year, the reorder point can be calculated as:
900
R
P L Daily demand L 10 36 units
250
250
This model suggests an order of 89 units whenever the inventory drops to 36 units. The last
unit will be used just as the next order arrives. Average inventory will be 89/2 44.5 units.
In practice, it might be advisable to keep some safety stock that must be added to the average
inventory. Also, the bottom of the total cost curve (see Figure 8–1) is relatively flat (and asymmetric) so that there might be advantages in ordering 96 (eight dozen) or 100 units instead.
In this case, these quantities would cost approximately an additional $2.50 and $6.25, respectively, out of a total annual cost of about $41,500. These costs are the additional ordering and
carrying costs resulting from the additional units ordered.
The assumptions behind the EOQ model place some rather severe restrictions on its
general applicability. Numerous other models have been developed that take into account
relaxation of one or more of the assumptions. The reader may wish to refer to books on
inventory management for a more extensive discussion.
Fixed-Period Models
In many situations, ordering every so often rather than whenever the stock reaches a certain
level is desirable from an operations viewpoint. The scheduling of workload is easier when
employees can be assigned to check certain classes of inventory every day, week, month,
and so on.
In fixed-quantity models, orders are placed when the reorder point is reached, but in
fixed-period models, orders are placed only at review time. The inventory level, therefore,
must be adjusted to prevent stockouts during the review period and lead time.
Fixed-period models attempt to determine the optimal order period (O). The minimum
cost period can be determined as follows. There are R/O cycles per year and, therefore, T
(the fraction of the year) is O/R. This value of O can then be substituted in the EOQ formula to give:
____
ToptR 兹
2RS
KC
_____
or
Topt 兹 RKC
2S
Using the values given for the previous example:
_______________
Topt 2 50
兹 900 0.25 45 0.1
or,
10 times per year
For a year of 250 working days, this is 25 working days, or once every five weeks. The
optimum order quantity, EOQ, is RTopt or 90 units. This is the same result as before. Organizational procedures may make a review every four weeks or monthly more attractive.
In this case, T would change to 0.08 and O to 72 at an additional cost of $23.77 per year
over the optimum value.
Probabilistic Models and Service Coverage
The aforementioned models assume that all parameters are known absolutely and do not
change over time. It is far more common to have some variability in demand, lead times,
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206 Purchasing and Supply Management
supply, and so on. Probabilistic lot size models take these variations into account. The
models are more complex than the deterministic ones above, but the probabilistic approach
gives more information on likely outcomes.
Buffer or Safety Stocks and Service Levels
For buffer or safety stocks, the major decision variable is how much buffer inventory
to carry to give the desired service coverage. The service coverage can be defined as
the portion of user requests served. If there are 400 requests for a particular item in
a year and 372 were immediately satisfied, the service coverage would be 372/400 =
93 percent.
Service coverage also can be defined as the portion of demand serviced immediately.
If the 372 orders in the above example were for one unit each and the 28 other unserviced
ones, for five units each, the total yearly demand would be for 372 + 140 = 512 units. The
service coverage would be 372/512, or 73 percent. It is obviously important to understand
exactly what is meant by service coverage in an organization.
Holding a large inventory to prevent stockouts, and thus to maintain a high service coverage, is expensive. Similarly, a high number of stockouts are costly. Stockout costs are
often difficult and expensive to determine but nevertheless real. Setting service coverage
requires managers to make explicit evaluations of these costs so that the appropriate balance between carrying and stockout can be achieved.
Trade-offs between holding inventory and stocking out can be assessed quantitatively
if accurate data are available, such as inventory holding costs, stockout costs, and demand
or supply variability. However, because of the expense and difficulty of obtaining such
costs and probability estimates for individual items, managers often set service coverage
arbitrarily, typically about 95 percent, implying a ratio of stockout to holding costs of
about 19 to 1.
In practice, setting and managing service coverage is difficult because of the complexity
of item classification, function, and interdependence. Service coverage need not be as high
on some items as on others, but an item that may be relatively unimportant to one customer
may be crucial to another. If the customer is an assembly line, low service coverage on one
component makes higher service coverage on others unnecessary. Also, some customers
will tolerate much lower service coverage than will others. Within an organization, internal
departments are sometimes regarded as customers, and service coverage attained is one
measure of supply management’s effectiveness. It is useful to stress that service coverage
and inventory investment are closely related. It becomes expensive to achieve high service
coverage, and a high service coverage expectation without the necessary financial backup
can lead only to frustration. Supply is, of course, also interested in service coverage as it
pertains to supplier performance.
Service coverage can be used to determine the appropriate level of buffer inventory. The
situation is shown in Figures 8–3 and 8–4. Four situations can arise as shown from left to
right in Figure 8–3.
1.
2.
3.
4.
joh77899_ch08_198-230.indd 206
Only some of the buffer inventory was used.
No buffer inventory remained, but there was no stockout.
There was a stockout.
All the buffer inventory remained.
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Chapter 8
FIGURE 8–3
Fixed-OrderQuantity
Model Buffer
Inventory and
Variation in
Demand
Quantity and Inventory 207
Inventory
(units)
Q
L
P
4
B
2
1
Buffer inventory
0
3
Time
FIGURE 8–4
Determination
of Buffer
Inventory
to Achieve
Desired
Coverage
Inventory
(units)
L
P
Expected distribution of
usage during lead time
Most likely usage level
B
0
Time
Service coverage level—
95 percent of area under
distribution curve above
this point
Figure 8–4 starts with an EOQ model except that it is not certain how many units will be
used between placing and receipt of an order. Figure 8–4 targets desired service coverage
at 95 percent, given the standard deviation of average daily demand, an assumption of a
normal demand distribution, and a most likely usage level.
The complexity of probabilistic models increases greatly when lead times, usable
quantities received, inventory shrinkage rates, and so on, also vary under conditions of
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208 Purchasing and Supply Management
uncertainty, when nonnormal distributions are observed, and when the variations change
with time. Simulation models and other more advanced statistical techniques can be used
to solve these complex situations.
PLANNING REQUIREMENTS AND RESOURCES
One of the assumptions behind the lot-sizing models just described is that demand for the
item being purchased or made is independent of all other demands. This situation is true
for most manufacturers’ finished goods. However, subassemblies, raw materials, and parts
do not exhibit this independence. Demand for these items is dependent on the assembly
schedule for finished goods. For example, each car assembled needs one windshield, one
steering wheel, but four tires plus a spare. Similarly, many MRO items depend on maintenance schedules. Recognition of the existence of demand dependence lies behind the
technique known as material requirements planning (MRP).
Material Requirements Planning (MRP)
MRP systems attempt to support the activities of manufacturing, maintenance, or use by
meeting the needs of the master schedule. To determine needs, MRP systems need an accurate bill of materials for each final product or project. These bills can take many forms,
but it is conceptually advantageous to view them as structural trees.
Not all organizations have been successful in implementing MRP systems. Implementation may take years and involve major investments in training, data preparation, and
organizational adjustments as well as in computer software and hardware. However, most
organizations with successfully implemented systems feel that the reduced inventory, lead
times, split orders, and expediting; increased delivery promises met; and discipline resulting from MRP make the investment worthwhile. MRP systems allow rapid replanning and
rescheduling in response to the changes of a dynamic environment.
MRP Inputs
There are three basic MRP inputs.
1. Master production schedule. The whole system is driven by the requirements forecast
by time period (the master production schedule), which details how many end items are
to be produced during a specified time period.
2. Structured bill of materials (BOM). The BOM uses information from the engineering and/or process records to detail the subcomponents necessary to manufacture one
finished item.
3. Inventory record. This contains information such as open orders, lead times, and lotsize policy so that the quantity and timing of orders can be calculated.
The logic of MRP allows simultaneous determination of how much and when to order.
The calculations hinge on the assumptions that all information is accurate and known with
certainty and that material will be ordered as required. MRP systems can help production
meet schedules, avoid equipment downtime, adjust to order quantity changes, and identify
the need to expedite late orders.
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Chapter 8
Quantity and Inventory 209
MRP Lot Sizing
Lot-sizing rules must be assigned to each item before the MRP plan can be computed. The
selection of a lot-sizing rule is important because it affects inventory holding costs and
operations costs, such as setup costs.
The four basic lot-sizing rules are (1) lot-for-lot (L4L), (2) economic order quantity
(EOQ), (3) least total cost (LTC), and (4) least unit cost (LUC).
1. Lot-for-lot. This is the most common technique. It does not take into account setup
costs, carrying costs, or capacity limitations. Lot sizing is based on producing net requirements for each period.
2. Economic order quantity (EOQ). The EOQ lot-sizing technique balances inventory holding and setup (or order) costs. It uses the EOQ formula to set lot sizes,
which requires estimates for annual demand, inventory holding costs, and setup (or
order) costs.
3. Least-total-cost (LTC). The least-total-cost method compares the cost implications of
various lot-sizing alternatives and selects the lot size that provides the least total cost.
The LTC method is a dynamic lot-sizing technique.
4. Least-unit-cost. The least-unit-cost method is also a dynamic lot-sizing method. It factors inventory holding and setup (or order) costs into the unit cost.
Lot sizing is a difficult issue when using MRP. Because most lost-sizing techniques
require cost and annual demand information, accuracy of the data used will determine the
effectiveness of the decisions made.
Capacity Requirements Planning (CRP)
With advances in information systems technology, a number of improvements have been
made to MRP systems that can help managers with planning and coordinating production
and supply. One significant advance in MRP systems has been the addition of capacity
requirements planning (CRP).
Capacity is how much work can be done in a set amount of time. CRP performs a
similar function for manufacturing resources that MRP performs for materials. When the
MRP system has developed a materials plan, CRP translates the plan into the required
human and machine resources by workstation and time bucket. It then compares the
required resources against a file of available resources. If insufficient capacity exists,
the manager must adjust either the capacity or the master production schedule. This
feedback loop to the master production schedule results in the term closed-loop MRP to
describe this development.
The CRP module is often linked to a module that controls the manufacturing plan on the
shop floor. The goal is to measure output by work center against the previously determined
plan. This information allows identification of trouble spots and is necessary on an ongoing
basis for capacity planning.
Manufacturing Resource Planning (MRP II)
MRP II links the firm’s planning processes with the financial system. MRP II systems combine the capability of “what if ” production scenario testing with financial and cash flow
projections to help achieve the sales and profitability objectives of the firm.
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210 Purchasing and Supply Management
Enterprise Resource Planning (ERP) Systems
Many companies use ERP systems, which include MRP modules, to integrate business
systems and processes. ERP systems are software that allows all areas of the company—
manufacturing, finance, sales, marketing, human resources, and supply—to combine and
analyze information. ERP can provide a link from customer orders through the fulfillment
processes. Therefore, fully implemented ERP systems allow supply to be aware of orders
received by sales, manufacturing to be aware of raw material delivery status, sales to understand product or service lead times and availability, and financial transactions and commitments to be communicated directly into the financial accounting system. A thorough
discussion of e-supply applications is provided in Chapter 4.
Consequently, a modern MRP system is thus a lot more than simply a device to calculate
how much material to obtain and when to do so. It is an information and communication system
that encompasses all facets of the organization. It provides managers with performance measures, planned order releases (purchase orders, shop orders, and rescheduling notices), and the
ability to simulate a master production schedule in response to proposed changes in production
loading ( for example, by a new order, delayed materials, a broken machine, or an ill worker).
The integration required of such systems forces organizations to maintain highly accurate information, abandon rules of thumb, and use common data in all departments. The results are
reduced inventory levels, higher service coverage, ready access to high-quality information,
and, most importantly, the ability to replan quickly in response to unforeseen problems.
Supply Implications of MRP
The tight control required by MRP means that supply records regarding quantities, lead
times, bills of material, and specifications must be totally accurate and tightly controlled. The
on-time delivery required of MRP needs cooperation from suppliers. Purchasers, therefore,
must educate their suppliers to the importance of quantity, quality, and delivery promises to
the purchaser. Such education should enable purchasers to reduce their safety stock.
Many MRP systems have purchasing modules that perform many of the routine clerical
supply tasks, making supply’s job more analytical and strategic. The long-term nature of
the MRP planning horizon, typically a year, means longer-term planning for supply and
the negotiation of more long-term contracts with annual volume-based discounts. These
contracts have more frequent order release and delivery, often in nonstandard lot sizes.
Quantity discounts on individual orders become less relevant in favor of on-time delivery
of high-quality product.
Purchasers must understand the production processes both of their own organizations
and of their suppliers. The tighter nature of MRP-using organizations increases the responsibility of supply to be creative and flexible in providing assistance to minimize the inevitable problems that will occur in supply lines. The MRP system provides purchasers with an
information window to production scheduling so that they are better able to use judgment
in dealing with suppliers. Because of the reduced resource slack that results from MRP,
purchasers must incorporate deexpediting into their activities as well as the more usual
expediting role. The integrating and forward-looking nature of MRP means an increase in
specialization in the supply department. For example, the buyer-planner is a person who
uses MRP to assure smooth functioning of the interface between the purchaser’s and supplier’s processes. Also, specialization will be based on finished product line outputs rather
than on raw material inputs.
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Chapter 8
Quantity and Inventory 211
In contrast to MRP, just-in-time production methods can achieve many of the goals of
MRP in conjunction with MRP or on a stand-alone basis.
FUNCTIONS AND FORMS OF INVENTORIES
Understanding where (and why) inventory should be positioned in the supply chain can improve customer service, lower total costs, or increase flexibility. Proper inventory management requires a thorough understanding of both the functions and the forms of inventory.
The Functions of Inventory
Many purchases cover repetitive items often held in inventory. Thus, inventory policy
has a great influence on purchase quantity decisions. The questions of how much to order,
when, and how much to carry in stock are key decisions subject to continuous improvement examination along with the focus on quality and customer, employee, and supplier
satisfaction. It is important in making delivery, inventory, or purchase order size decisions
to understand why inventories exist and what the relevant trade-offs are. Inventories exist
for many purposes, including:
•
•
•
•
To provide and maintain good customer service.
To smooth the flow of goods through the productive process.
To provide protection against the uncertainties of supply and demand.
To obtain a reasonable utilization of people and equipment.
The following classification of inventory functions reveals the multipurpose roles
played by inventories.
Transit or pipeline inventories are used to stock the supply and distribution pipelines
linking an organization to its suppliers and customers as well as internal transportation
points. They exist because of the need to move material from one point to another. Obviously, transit inventories are dependent on location and mode of transportation. A decision
to use a distant supplier with rail transport will probably create a far larger raw materials
transit inventory than a decision to use a local supplier with truck delivery.
In just-in-time (JIT) production, a variety of means are used to reduce transit inventories, including the use of local suppliers, small batches in special containers, and trucks
specifically designed for side loading in small quantities.
Cycle inventories arise because of management’s decision to purchase, produce, or sell
in lots rather than individual units or continuously. Cycle inventories accumulate at various
points in operating systems. The size of the lot is a trade-off between the cost of holding
inventory and the cost of making more frequent orders and/or setups. A mathematical description of this relationship, the economic order quantity, has already been discussed. In
JIT, the need for cycle inventories is reduced by setup cost and time reduction.
Buffer or uncertainty inventories or safety stocks exist as a result of variability in demand or supply. Raw material, purchased parts, or MRO buffer stocks give some protection against the variability of supplier performance due to shutdowns, strikes, lead-time
variations, late deliveries to and from the supplier, poor-quality units that cannot be accepted, and so on. Work-in-process buffer inventories protect against machine breakdown,
employee illness, and so on. Finished goods buffers protect against unforeseen demand or
production failures.
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212 Purchasing and Supply Management
FIGURE 8–5
Decision to
Inventory in
Anticipation of
a Possible Price
Increase
DECISION
ALTERNATIVES
DECISION
VARIABLES
OUTCOMES
s
ce
Pri
l
a
ion
it
add
e
s
ry
a
rch vento
Pu
n
i
se
rea
inc
P
Pri
ce d
oes
inc
rea not
se
1–
P
No
add
inv itiona
ent
ory l
Price increase avoided
Carrying cost incurred
es
ce
Pri
as
cre
in
Carrying cost
incurred
Price increase
incurred
P
Pri
ce
doe
s
inc
rea not
se
1–
P
Carrying cost
avoided
Management efforts to reduce supply variability may have substantial payoffs in reduced inventories. Options may include increasing supply alternatives, using local sources,
reducing demand uncertainty, reducing lead time, or having excess capacity. Buffer inventory levels should be determined by balancing carrying cost against stockout cost.
Buying in expectation of major market shortages is a longer time-frame variation of buffer inventory. It may require large sums and top management strategic review. Chapter 10
discusses forward buying more fully.
Another class of buffer stock is that purchased in anticipation, but not certainty, of a
price increase. In this case, the trade-off is between extra carrying costs and avoidance of
higher purchase cost. This trade-off can be structured as shown in Figure 8–5. Obviously,
intermediate levels of price increase and the timing of increases also will be identified.
Other buffer stock trade-offs can be structured similarly.
Anticipation or certainty inventories are accumulated for a well-defined future need.
They differ from buffer stocks in that they are committed in the face of certainty and
therefore have less risk attached to them. Seasonal inventories are an excellent example.
Stocking commodities at harvest time for further processing during the year is a typical
example. Reasons for anticipation stocks may include strikes, weather, shortages, or announced price increases.
The managerial decision is considerably easier than with buffer stocks because the certainty of events makes probability estimates unnecessary. Unfortunately, in times of shortages and rapid price increases, organizations may not be able to commit enough funds to
meet the clear need for more anticipation stocks. Public organizations working under preestablished budgets may not be able to obtain authorization and funds. Many organizations
that are short of working capital may be similarly frustrated.
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Chapter 8
Quantity and Inventory 213
Decoupling inventories make it possible to carry on activities on each side of a major
process linkage point independently of each other. The amounts and locations of raw material, work-in-process, and finished goods decoupling inventories depend on the costs and
increased operating flexibility benefits of having them.
All inventories perform a decoupling function, whether they be transit, cycle, buffer,
or certainty inventories. When the prime purpose is to decouple, and space and time have
been designed into the process to accommodate them, it is appropriate to recognize decoupling inventory as a unique category of its own. It gives flexibility and independence to
both parties and is an excellent area for negotiations. Many contracts specify that a supplier
maintain a certain finished goods inventory. A finished goods inventory performs a decoupling function between the supplier’s manufacturing process and the customers’ process.
By examining the functions of inventory, it is clear that they are the result of many
interrelated decisions and policies within an organization. At any time, any of the inventory functional types will be physically indistinguishable from the others. Frequently, a
particular item may serve many of the functions simultaneously. Why, then, classify inventories by function? The answer lies in the degree of controllability of each class. Some
inventories are essentially fixed and uncontrollable, whereas others are controllable. A
management directive to reduce total inventories by 20 percent combined with, supply and
marketing policies and prior commitments on cycle and seasonal inventories, could reduce
decoupling and buffer inventories to nearly zero with potentially disastrous results.
The Forms of Inventory
Inventories may be classified by form as well as function; indeed, this classification is
much more common. The five commonly recognized forms are (1) raw materials, purchased parts, and packaging; (2) work-in-process; (3) finished goods; (4) MRO items; and
(5) resale items. Scrap or obsolete material, although technically regarded as inventory, is
addressed in Chapter 16.
Raw materials, purchased parts, and packaging for manufacturers are stocks of the basic
material inputs into the organization’s manufacturing process. As labor and other materials are added to these inputs, they are transformed into work-in-process inventories. When
production is completed, they become finished goods. In general, the forms are distinguished by the amount of labor and materials added by the organization. The classification
is relative in that a supplier’s finished goods may become a purchaser’s raw materials.
For resource industries, service organizations, and public organizations, MRO inventories may be substantial. In resource industries, a significant portion of such inventory may
be maintenance or repair parts to support the heavy capital investment base. In resale organizations, the main categories are goods for resale and inventories to maintain building and
equipment. For many consumer goods industries, such as food and beverage, packaging represents a major purchase inventory category with substantial environmental implications.
Inventory Function and Form Framework
Combining the five forms and five functions of manufacturing inventory gives the 25 types
of inventory that make up the inventory profile of an organization. They are presented in
Figure 8–6 along with some of the managerial decision variables affecting each type. Not
all inventory types will be present to the same extent in each organization; indeed, some
may be completely absent. The 25 types make inventory control a more complex but a
more easily focused task.
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214 Purchasing and Supply Management
FIGURE 8–6 Inventory Forms and Function
Raw Materials,
Purchased
Parts, and
Packaging
1
Work-in-Process
2
MRO
4
Resale
5
Logistics Decisions
1 Transit
(pipeline)
Design of supply
system,
supplier
location,
transportation
mode
2 Cycle (EOQ,
lots)
Design of layout
and materials
handling
system
Design of
plant
location and
product
distribution
system
Supplier location, Warehouse location,
transportation
distribution,
mode, small
transportation
shipments
mode
Product/Process Design Decisions
Order size, order
cost
Inventory Function
Finished Goods
3
Lot size, setup
Distribution
costs, lot
sizes
OEM or not and
order size
Order size
and order cost
Management Risk Level Decisions and Uncertainty
3 Buffer
(uncertainty)
Probability
distributions of
price, supply
and stockout,
and carrying
costs
Probability
distributions
of machine
and product
capabilities
Probability
distributions
of demand
and
associated
carrying and
stockout cost
Probability
distributions of
breakdowns
during use
Probability
distributions of
demand associated
with carrying and
stockout costs
4 Anticipation
Price/Availability/Decisions and Uncertainty, Seasonality, Capacity
(price)
Capacity,
Demand
Maintenance
Supply and demand
(shortage) Know future
supply and
production
patterns
planning
patterns and price
demand price
costs of hire,
(seasonal)
projects
levels
levels
fire, transfer,
overtime, idle
time, etc.
5 Decoupling
(interdepenDependence/
dence)
independence
from supplier
behavior
joh77899_ch08_198-230.indd 214
Production Control Decisions
Dependence/
independence
of successive
production
operations
Dependence/
independence
from market
behavior
Stock at vendor
or at user
Stock at vendor
or buyer stock
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Quantity and Inventory 215
The behavior of inventories is a direct result of diverse policies and decisions within an
organization. User, finance, production, marketing, and supply decisions can all have crucial
influences on stock levels. Long-term fixed marketing or supply policies may render finished
goods transit, raw materials transit, and cycle inventories quite inflexible, whereas short-term
production scheduling may provide a great amount of flexibility of work-in-process inventories. Long-term supply contracts coupled with falling demand may lead to raw materials
accumulation. Effective supply managers must recognize the behavior and controllability of
each type of inventory in both the short and long terms. For effective supply management,
they must also coordinate the policies and decisions of all functional areas.
Often managers use various informal rules of thumb in their decision making. A common one is turnover in number of times per year. The rule of thumb would dictate that as
the use doubles, inventories should also double. However, a closer look must be taken at
the components of that inventory.
Cycle inventories, produced in economic order lots (see earlier section), increase proportionally to the square root of demand, so, as demand doubles, cycle inventories should rise by
a factor of only about 1.4. Ordering raw materials or storing them may have quite different
cost structures from setting up machines, issuing production orders, or storing finished goods.
Transit inventories depend on supply and distribution networks. A change in the distribution system to accommodate extra volume could more than double or even reduce finished
goods transit inventory. Anticipation stocks vary with the pattern of demand, not demand
itself. Decoupling inventories may remain unchanged. Buffer inventories may increase or
decrease in response to demand and supply instabilities. Many of these effects will balance
each other out, but the point remains: Rules of thumb are crude ways of controlling inventory levels. Even if they seem to work, managers never know if they are the best available.
Any set of rules must be interpreted intelligently and reevaluated and tested periodically.
Companies that have adopted lean supply practices achieve inventory reductions by
eliminating the root cause for the purpose of holding the inventory. For example, cycle
inventories are brought down by reducing setup times; decoupling inventories are reduced
by better planning and better quality; and safety stocks are lowered because of lower supply and/or demand variability, reduced quality problems, or better on-time delivery performance. It is a continuing challenge to search for better ways to control inventories.
INVENTORY MANAGEMENT
Along with the key decisions of how much and when to order is the question of how to inventory effectively. This is a challenge in most organizations. In this text we address several
inventory management tools and techniques, including inventory costing; ABC classification; lean supply, JIT, and kanban systems; and supply chain inventory management.
Costs of Inventories
Because of the high cost of carrying inventory, many systems have been developed to
reduce stocks. Japanese manufacturers have spearheaded lean supply chain practices, including just-in-time systems. Nevertheless, it is useful to understand the nature and costs
of inventories so that appropriate policies and procedures can be developed for specific
organizational needs. North American organizations have begun to rely heavily on material
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216 Purchasing and Supply Management
requirements planning systems that have similar goals of reducing inventories wherever
possible by having accurate, timely information on all aspects of the users’ requirements,
thorough coordination of all departments, and rigorous adherence to the system.
For every item carried in inventory, the costs of having it must be less than the costs
of not having it. Inventory exists for this reason alone. Inventory costs are real but are not
easy to quantify accurately. The relevance of cost elements in a given situation depends on
the decisions to be made. Many costs remain fixed when the order size of only one item is
doubled, but the same costs may well become variable when 5,000 items are under consideration. The main types of inventory costs are described below.
Carrying, holding, or possession costs include handling charges; the cost of storage
facilities or warehouse rentals; the cost of equipment to handle inventory; storage, labor,
and operating costs; insurance premiums; breakage; pilferage; obsolescence; taxes; and
investment or opportunity costs. In short, any cost associated with having, as opposed to
not having, inventory is included.
The cost to carry inventory can be very high. For example, recent estimates of the annual cost to carry production inventory ranged from 25 to 50 percent of the value of the inventory. Many firms do not do a very good job of estimating carrying costs. While there are
several methods for calculating inventory carrying costs, the basic elements are (1) capital
costs, (2) inventory service costs, (3) storage space costs, and (4) inventory risk costs.1
Once the firm has estimated its carrying costs as a percentage of inventory value, annual
inventory carrying costs can be calculated as follows:
(carrying cost per year) (average inventory value)
(inventory carrying cost as a % of inventory value)
Average inventory value (average inventory in units) (material unit cost)
CC Q兾2 C I
where
CC carrying cost per year
Q order or delivery quantity for the material, in units
C delivered unit cost of the material
I inventory carrying cost for the material, as a percentage
of inventory value
Ordering or purchase costs include the managerial, clerical, material, telephone, mailing, fax, e-mail, accounting, transportation, inspection, and receiving costs associated with
a purchase or production order. What costs would be saved by not ordering or by combining two orders? Header costs are those incurred by identifying and placing an order with a
supplier. Line item costs refer to the cost of adding a line to a purchase order. Most orders
will involve one header and several line item costs. Electronic data interchange (EDI) and
Internet-based ordering systems try to reduce ordering or purchase costs significantly as
well as reduce lead time at the same time.
Setup costs refer to all the costs of setting up a production run. Setup costs may be substantial. They include such learning-related factors as early spoilage and low production output
until standard rates are achieved as well as the more common considerations, such as setup,
employees’ wages and other costs, machine downtime, extra tool wear, parts (and equipment)
1
Doug M. Lambert, James R. Stock, and Lisa M. Ellram, Fundamentals of Logistics Management (Burr
Ridge: IL: McGraw-Hill/Irwin, 1998).
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Quantity and Inventory 217
damaged during setup, and so on. Both the purchaser’s and supplier’s setup costs are relevant. It should be pointed out that the reduction of setup costs and times permits smaller
production runs and hence smaller purchaser order quantities and more frequent deliveries.
Stockout costs are the costs of not having the required parts or materials on hand when
and where they are needed. They include lost contribution on lost sales (both present and
future), changeover costs necessitated by the shortage, substitution of less suitable or more
expensive parts or materials, rescheduling and expediting costs, labor and machine idle
time, and so on. Often, customer and user goodwill may be affected and occasionally penalties must be paid. The impact of stockouts on customers will vary. In a seller’s market,
an unsatisfied customer may not be lost as easily as in a buyer’s market. In addition, each
individual customer will react differently to a shortage.
In many organizations, stockout costs are very difficult to assess accurately. The general
perception, however, is that stockout costs are substantial and much larger than carrying
costs. Stockout costs, here discussed as they relate to inventory, are similar for late delivery
or quantity shortfalls.
Variations in delivered costs are costs associated with purchasing in quantities or at
times when prices or delivery costs are higher than at other quantities or times. Suppliers often offer items in larger quantities or at certain times of the year at price and transportation discounts. Purchases in small quantities or at other times may result in higher
purchase and transportation costs, but buying in larger quantities may result in significantly
higher holding costs. The quantity discount problem will be discussed in Chapter 10.
Many inventory costs may be hard to identify, collect, and measure. One can try to trace
the individual costs attributable to individual items and use them in decision making. Usually such costs will be applicable to a broader class of items. A second approach is to
forecast the impact of a major change in inventory systems on various cost centers. For
example, what will be the impact on stores of a switch to systems contracting or vendormanaged inventories for some low-value items? Or what would be the impact of a justin-time system on price, carrying, ordering, and stockout costs? Because most inventory
models are based on balancing carrying, order, and stockout costs to obtain an optimal order
and inventory size, the quality and availability of cost data are important considerations.
ABC Classification
A widely used classification of both purchases and inventories is based on monetary
value. In the 19th century, the Italian economist Vilfredo Pareto observed that, regardless of the country studied, a small portion of the population controlled most of the
wealth. This observation led to the Pareto curve, whose general principles hold in a
wide range of situations. In materials management, for example, the Pareto curve usually
holds for items purchased, number of suppliers, items held in inventory, and many other
aspects. The Pareto curve is often called the 80-20 rule or, more usefully, ABC analysis,
which results in three classes, A, B, and C, as follows when applied to inventory:
joh77899_ch08_198-230.indd 217
Class
Percentage of Total
Items in Inventory
Percentage of Total Dollars
Tied up in Inventory
A
B
C
10
10–20
70–80
70–80
10–15
10–20
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218 Purchasing and Supply Management
These percentages may vary somewhat from organization to organization, and some organizations may use more classes. The principle of separation is very powerful in materials
management because it allows concentration of management efforts in the areas of highest
payoff. For example, a manufacturer with total annual purchases or spend of $30.4 million
had the following breakdown:
Number of
Items
Percentage of
Items
Annual Purchase
Value
1,095
2,168
7,660
10.0%
19.9
70.1
$21,600,000
5,900,000
2,900,000
10,923
100%
Percentage Annual
Purchase Volume
Class
71.1%
19.4
9.5
$30,400,000
A
B
C
100%
A similar analysis of the organization’s inventories would be expected to show a similarly high portion of total value from a relatively small number of items.
Purchase value is a combination of unit price and number of units, so it is not sufficient
to classify either high-priced or high-unit-volume items as A’s on that basis alone. Annual
value (e.g., Unit value Annual value Total annual value) must be calculated and a
classification into three groups on this basis is a good starting point (see Figure 8–7).
How can a supply manager use such a classification? Far more managerial time and
effort should be spent on A and B items than on C items. Because supply assurance and
FIGURE 8–7
ABC
Classification
of Inventory
100
Total dollar investment
(percent)
90
75
Low dollar
investment
“C” items
Intermediate
dollar
investment
“B” items
High
dollar
investment
“A” items
20
50
100
Number of items
(percent)
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Chapter 8
Quantity and Inventory 219
availability are usually equally important for all items, it is common to manage C items
by carrying inventories, by concentrating a wide variety of requirements with one or a few
suppliers, by arranging stockless buying agreements or systems contracting, by using procurement cards, by exploiting e-catalogs, and by reviewing the items infrequently. These
techniques reduce documentation and managerial effort (for most items) but maintain high
service coverage.
A items are particularly critical in financial terms and are, therefore, barring other
considerations, normally carried in small quantities and ordered and reviewed frequently. B items fall between the A and C categories and are well suited to a systematic
approach with less frequent reviews than A items. It should be noted that some B
or C items may require A care because of their special nature, supply risk, or other
considerations.
Vendor- or Supplier-Managed Inventory (VMI/SMI)
Supplier- or vendor-managed inventory, systems contracting, or stockless buying is a more
sophisticated merging of the ordering and inventory functions than blanket contracts. Systems contracts rely on periodic billing procedures; allow nonpurchasing personnel to issue
order releases; employ special catalogs; require suppliers to maintain minimum inventory
levels, but normally do not specify the volume of contract items a buyer must buy; and
improve inventory turnover rates.
This technique has been used most frequently in buying stationery and office supplies,
repetitive items, maintenance and repair materials, and operating supplies (MRO). This
latter class of purchases is characterized by many different types of items, all of comparatively low value and needed immediately when any kind of a plant or equipment failure
occurs. The technique is built around a blanket-type contract that is developed in great
detail regarding approximate quantities to be used in specified time periods, prices, provisions for adjusting prices, procedures to be followed in picking up requisitions daily and
making delivery within a short time (normally 24 hours), simplified billing procedures, and
a complete catalog of all items covered by the contract.
Generally the inventory of all items covered by a contract is stored by the supplier, thus
eliminating the buyer’s investment in inventory and space. Requisitions for items covered
by the contract go directly to the supplier and are not processed by the purchasing department. The requisition is used by the supplier to pull stock, to pack, to invoice, and as a
delivery slip. The streamlined procedure reduces paper-handling costs for the buyer and
the seller and has been a help in solving the small-order problem.
Lean Supply, Just-in-Time (JIT), and Kanban Systems
Lean thinking is a management philosophy focused on eliminating seven forms of waste:
1.
2.
3.
4.
5.
6.
7.
joh77899_ch08_198-230.indd 219
Overproduction.
Waiting, time in queue.
Transportation.
Nonvalue-adding processes.
Inventory.
Motion.
Costs of quality: scrap, rework. and inspection.
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220 Purchasing and Supply Management
Lean Supply
Lean supply is an approach in which relationships with suppliers are managed based on
a long-term perspective to eliminate waste and add value. It is based on Japanese manufacturing concepts pioneered by Toyota. Lean systems have been adopted in many organizations, under a variety of names, such as the Delphi Manufacturing System at the
automotive parts maker Delphi Corporation. However, the Toyota production system is
generally recognized as the best model of lean operations.
Just-in-Time (JIT)
The most popular system that incorporates the lean philosophy is just-in-time (JIT). Under
a JIT system, components, raw materials, and services arrive at work centers exactly as
they are needed. This feature greatly reduces queues of work-in-process inventory. The
goals of JIT production are similar to those of MRP—providing the right part at the right
place at the right time—but the ways of achieving these goals are radically different and the
results impressive. Whereas MRP is computer based, JIT is industrial engineering based.
JIT focuses on waste elimination in the supply chain, and there are many JIT features that
are good practice in any operation, public or private, manufacturing or nonmanufacturing.
In JIT, product design begins with two key questions:
• Will it sell? and
• Can it be made easily?
These questions imply cooperation between marketing and operations. Once these questions have been answered positively, attention turns to design of the process itself. The
emphasis is on laying out the machines so that production will follow a smooth flow. Automation (often simple) of both production and materials handling is incorporated wherever
possible. Frequently, U-shaped lines are used, which facilitate teamwork, worker flexibility, rework, passage through the plant, and material and tool handling. In process design,
designers strive to standardize cycle times and to run a constant product mix, based on the
monthly production plan, through the system. This practice makes the production process
repetitive for at least a month.
The ability to smooth production implies very low setup and order costs to allow the
very small lot sizes, ideally one. JIT treats setup and order costs as variable rather than
as the fixed costs implied by the EOQ equation. By continuously seeking ways to reduce
setup times, the Japanese were the first to have managed impressive gains. Setups, which
traditionally required three to four hours, have been reduced to less than a minute in some
JIT facilities.
These dramatic improvements have been achieved by managerial attention to detail on
the shop floor; the development and modification of special jigs, fixtures, tools, and machines; and thorough methods training. Setup simplification is aided by their willingness
to modify purchased machines, their acquisition of machines from only a few sources, and
their frequent manufacture of machines in-house—often special purpose, light, simple, and
inexpensive enough to become a dedicated part of the process. Order costs, conceptually
similar to setup costs, have similarly been reduced.
One of the necessary corollaries of having components and materials arrive just as they
are needed is that the arriving items must be perfect. In JIT, a number of interrelated principles are used to ensure high-quality output from each step in the production process.
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Quantity and Inventory 221
1. Worker responsibility. Responsibility for quality rests with the maker of a part, not
with the quality control department. In addition, workers and managers habitually seek
improvement of the status quo, striving for perfection. Quality improvements are often
obtained from special projects with defined goals, measures of achievement, and endings.
Also, workers are responsible for correcting their own errors, doing rework, and so on.
2. Build-in quality. The use of production workers instead of quality control inspectors
builds quality in rather than inspecting it in. This feature and the small lot sizes allow
every process to be controlled closely and permit inspection of every piece of output.
Workers have authority to stop the production line when quality problems arise. This
aspect signifies that quality is a more important goal of the production system than output.
3. Compliance to quality standards. JIT insists on compliance to quality standards.
Purchasers reject marginally unacceptable items and visit supplier plants to check quality on the shop floor for themselves. Because such visits are frequent, JIT manufacturers document their quality in easily understood terms and post the results in prominent
places. This process forces the manufacturer to define quality precisely.
JIT control of quality is helped by the small lot sizes that prevent the buildup of large lots
of bad items. JIT tends to have excess production capacity so that the plants are not stressed
to produce the required quantities. Similarly, machines are maintained and checked regularly and run no faster than the recommended rates. Plant housekeeping is generally good.
The quality control department acts as a quality facilitator for production personnel and
suppliers, giving advice in problem solving. This department also does some testing, but
the tests tend to be on final products not easily assignable to a single production worker,
or special tests requiring special equipment, facilities, knowledge, or time not available
to personnel on the shop floor. Automatic checking devices are used wherever possible.
Where necessary, sample lots are chosen to consist of the first and last units produced
rather than a larger, random sample. Analytical tools include the standard statistical techniques, often known by workers, and cause-and-effect diagrams to help solve problems.
JIT requires great dedication by both workers and managers to hard work and helping
the organization. JIT workers must be flexible. They are trained to do several different
jobs and are moved around frequently. The workers are responsible for quality and output.
Workers continuously seek ways to improve all facets of operations and are rewarded for
finding problems that can then be solved.
In summary, JIT is a mixture of a high-quality working environment, excellent industrial
engineering practice, and a healthy focused factory attitude that operations are strategically
important. The order and discipline are achieved through management effort to develop
streamlined plant configurations that remove variability. The JIT system has often been
described as one that “pulls” material through the factory rather than pushing it through.
The use of a kanban system as a control device illustrates this point well.
Kanban Control Systems
Kanban is a simple but effective control system that helps make JIT production work.
Kanban is not synonymous with JIT, although the term is often incorrectly so used and the
two are closely related. Kanban is Japanese for “card”; the use of cards is central to many
Japanese control systems, including the one at Toyota, whose kanban system has received
much attention.
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222 Purchasing and Supply Management
Kanban systems require the small lot size features of JIT and discrete production units.
The systems are most useful for high-volume parts used on a regular basis. They are much
less useful for expensive or large items that cost a lot to store or carry, for infrequently or
irregularly used items, or for process industries that don’t produce in discrete units.
Two types of kanban systems exist: single card and double card. In double-card systems, two types of cards (kanban) exist: conveyance (C-kanban) and production (P-kanban).
Single-card systems use only the C-kanban. The two-card system’s operation uses the following rules.
1. No parts may be made unless there is a P-kanban authorizing production. Workers may
do maintenance, cleaning, or work on improvement projects until a P-kanban arrives
rather than making parts not yet asked for. Similarly, C-kanban controls the transport
of parts between departments.
2. Only standard containers may be used, and they are always filled with the prescribed
small quantity.
3. There is precisely one C-kanban and one P-kanban per container.
The system is driven by the user department pulling material through the system by the
use of kanban. The main managerial tools in this system are the container size and the number
of containers (and therefore kanban) in the system. The control is very precise, flexible, and
responsive. It prevents an unwanted buildup of inventory. For example, the actual assembly
of parts into a complete finished product provides the “pull” for more parts to be produced.
JIT and Inventory Management
Inventories often exist to cover up problems in supply or inside the organization. For example, a buffer inventory can protect a user from poor quality or unreliable delivery from a
marginal supplier. In JIT, the deliberate lowering of inventory levels to uncover such malpractices forces an organization to identify and solve the underlying problems or causes
for high and undesirable inventories. This deliberate inventory reduction is often seen by
some managers as a form of organizational suicide, a willingness to put continuity of supply, service, or operation at risk. However, enough organizations have experimented with
this concept (and survived) to show the merits of this practice. Diagrammatically, the lowering of inventory levels is frequently shown as a seascape of inventory with sharp rocks
of different heights underneath, representing the problems or malpractices that need to be
exposed sequentially.
JIT Implications for Supply Management
JIT has become sufficiently entrenched as a concept that its applicability is not in question,
only the extent to which it should be applied. Many companies are working closely with
their suppliers to implement JIT.
There are a number of implications of JIT for supply management. First, suppliers must
deliver high and consistent quality and with reliable delivery. This implies that concentrating purchases with fewer nearby suppliers may be necessary. The frequent delivery of
small orders may require a rethinking of the inbound transportation mode. For example, it
is normal to have a trucker follow a standard route daily to pick up, from 6 to 20 different
suppliers, small lots in a specially designed side-loading vehicle. Having delivery arranged
directly to the place of use eliminates double handling. Special moving racks designed
for proper protection, ease of counting, insertion, and removal also help improve material
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Chapter 8
Quantity and Inventory 223
handling. A lot of supplier training and cooperation is required to assist in the design and
operation of an effective JIT system.
In the minimum sense, JIT can refer to arranging for delivery just before a requirement
is needed. In this context, JIT has wide applicability beyond manufacturing—in public,
service, and other nonmanufacturing organizations. Reliability of delivery reduces the need
for buffer or safety stock, with the benefits that arise out of such inventory reduction.
In JIT there is a close cooperation between supplier and purchaser to solve problems,
and suppliers and customers have stable, long-term relationships. In keeping with the JIT
philosophy, suppliers, usually few in number, are often located close to their customers to
facilitate communication, on-time delivery of small lots of parts, low pipeline and safety
stocks, and low supply costs. The situation in many JIT companies is much like extensive
backward vertical integration. The organizations have close coordination and systems integration that smooth operations. The job of a purchaser in the JIT environment is that of a
facilitator, negotiator, communicator, and innovator.
Managing Supply Chain Inventories
Decisions regarding what inventory to have in the supply chain and where to have it have
important implications for customer service, working capital commitments, and ultimately
profitability. Companies such as Dell, Walmart, and Hewlett-Packard have demonstrated
the opportunities to combine lean supply chains with high levels of customer service.
Supply chain inventory management involves managing information flows and establishing operational design of the physical flow of the goods and services. Managing information
flows with supply chain partners is not an easy task. While information technology can be used
to link customers quickly and efficiently, firms are frequently required to make major investments in new systems to ensure compatibility. (See Chapter 4 for a more detailed examination
of information systems and information technology issues in supply chain management.)
However, coordinating information technology standards and software compatibility is
just part of the challenge. Because most suppliers frequently deal with multiple customers,
as opposed to focusing on a dominant downstream supply chain partner, issues relating to
confidentiality must be addressed, affecting what information should be shared and when
it should be communicated.
Operational design issues relate to production and fulfillment activities and can affect
performance factors such as lead times, quality, and lot sizes. For example, flexible manufacturing processes that can respond quickly to customer orders may allow reductions in
safety stock. Identifying appropriate modes of transportation is also important. Rail may
provide the lowest cost, but trucking provides faster door-to-door service and opportunities
to reduce transit inventories.
Finally, inventory fulfillment policies should take into account market conditions and
the impact on supplier operations. Broad policies such as “We keep four weeks of inventory for all A items” ignores variability of demand or supply for product groups or families.
It may be necessary to develop inventory level decision rules within group classifications
to ensure that appropriate stocks are maintained.
Order policies based on percentage of total demand can lead to large fluctuations in
demand from the retailer up the supply chain through the wholesaler, distributor, manufacturer, and raw materials supplier. This is known as the “bullwhip effect.” It can be addressed by sharing actual consumer demand with suppliers so that they can plan production
and have appropriate inventory available while keeping their costs low.
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224 Purchasing and Supply Management
DETERMINING QUANTITY OF SERVICES
So far this chapter has addressed quantity decisions about tangible goods. Buyers of services also make decisions about how much of a service to acquire, when to acquire, and
how to assure delivery of the specified services.
Aggregating Demand
As discussed in the forecasting section, forecasting aggregate demand for services is often
more unreliable than forecasting demand for goods. Multiple users, specifiers, order placers, and supplier relationship managers often leads to multiple contracts at varying prices
and terms with the same supplier. In these situations, organizationwide consumption management is impossible. This approach also challenges suppliers who must determine capacity requirements and project utilization rates.
Historically, supply has had a low involvement in managing services spend. Currently,
two approaches to better management of services spend are evident. One, bring the services categories under the umbrella of supply management. Two, take professional buying
tools and techniques to the users/consumers of services who have typically purchased services for themselves. Cooperative working relationships among buyers, users, and suppliers of services lead to clarity about requirements, consumption patterns, and opportunities
to reduce costs and improve performance.
Managing Consumption
Managing consumption of services is a challenge in many organizations. When management first attempts to consolidate services spend for a particular category, it may take
more time and human resources than anticipated just to make a reasonable estimate of
aggregated demand by spend category. This task is complicated by widely geographically
dispersed business units and local diversity. Nowhere is the tension between user desire
for customization and buyer’s goal of standardization and simplification more evident than
the services spend.
Dimensions of Services and Quantity Decisions
The dimensions of services quality discussed in Chapter 7 can also be applied to discussions about quantity of services to acquire. These are degree of tangibility, direction of the
service, production of the service, nature of demand, degree of standardization, and skills
required.
Degree of Tangibility
Decisions about how much to order and when to order are influenced by the degree of
tangibility. For a highly intangible service such as management consulting, the quantity
decisions may be focused on how many people need to be on the consulting team, what
qualifications they must have, and how long they need to be available. Determining the
length of a project may be difficult for both buyer and seller, complicating the ability of the
supplier to commit specific human resources to the project for its duration. Also, changes
inside both organizations may mean changes to personnel in the middle of a project. Loss
of personnel in either organization may change the timeline and quality of the service and
lead to disagreements about cost. For some projects, such as an IT installation, it may be
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Quantity and Inventory 225
difficult to accurately predict the length of the project and therefore the quantity of IT
professionals required. Contract terms may exacerbate the situation. Do contract terms
reward suppliers for satisfactory installation with incentives for timely completion or do
they allow the project time and cost to escalate?
Direction of the Service
When services are directed at people, quantity decisions may be made or heavily influenced
by the special needs of those most affected by the service. The ultimate user (consumer of
the service) likely will play a major role in the specification of the service. When services
are directed at buildings or equipment, quantity decisions may be more impersonal, but in
many cases humans are still affected by the decision. Consumption management efforts in
any case may be met with resistance internally.
Production of the Service
Services can be produced by people or equipment, or a combination of both. For services
with a high capital or asset component, potential suppliers can be assessed on asset capacity and availability as well as the state of their technology. For example, does a venue
have adequate space for the number of people expected to attend each event at a multiday
conference? For services with high labor intensity, a supplier’s capacity and availability of
people with the specified qualifications is the primary quantity concern.
Nature of the Demand
The demand for a particular service may be continuous, periodic, or discrete.
Continuous service: Insurance or a 365/24/7 around-the-clock security service or technical support.
Discrete or one-shot service: An interior decorator to suggest a new color scheme for
an office complex.
Periodic service: May be regular, such as once a week or once a month, as with regular
inspections, or it may vary with need, as in repair services.
The quantity of each type of service purchased impacts the price per service transaction
and the total cost of ownership of the service. One of the first assessments of services spend
is: How much of the service is acquired? In organizations with consumption management
initiatives, the next question is: How much of the service provided is unnecessary?
This leads to additional questions and possible answers about the quantity of services
required. For example, can a continuous service be reduced to a periodic service without loss
of quality and with a cost reduction? Does the organization need technical support available
365 days a year, 24 hours, 7 days per week? What are the benefits compared to the costs of
this level of service? If the number of times services were requested outside of normal business hours was small, perhaps a different contracting arrangement could be made for these
situations such as a higher fee for other times and a flat fee for normal operating times.
Services bundled with goods may be a good place to review the quantity of services purchased. Is the organization paying for services that it never uses? Is there another way to approach this spend category? For example, reducing the number of times floors are waxed per
year may be an excellent cost-cutting opportunity, but this must be compared to the impact of
a dirtier floor on customers’ perceptions of the organization as well as employee perceptions
and morale. Scrutiny of quantity of services provided may be an excellent cost-cutting focus.
joh77899_ch08_198-230.indd 225
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226 Purchasing and Supply Management
Degree of Standardization and Skills Required
In some organizations, categories of services have been placed along a continuum
from commodity-type standardized services to highly customized ones. This approach
allows the buying organization to streamline the acquisition process for services that
are highly commoditized and focus more on customized services. In terms of quantity
decisions, the internal user/specifier and the commodity manager may then develop
standard descriptions of commoditized services and, in effect, assign a stock keeping
unit (SKU) to each. A hiring manager can then designate quantities required by SKU
much as they would for a good. While it may sound dehumanizing to have an SKU
number on your forehead, it is an efficient and effective buying technique with quality
and cost implications. Because the human element is critical in many services, users/
specifiers may still want to interview candidates with the right SKU to determine best
fit with their operation.
With highly customized services, the volume procured clearly has price and cost implications. These must be carefully assessed to ensure that customized services are not
overspecified in the same way that buyers must watch out for overspecified goods.
Conclusion
Questions
for
Review
and
Discussion
Supply chain effectiveness is dependent on the assurance that quality, quantity, and delivery are consistently perfect. For goods, both quantity and delivery involve lot-sizing
and inventory decisions that, in turn, affect costs, productivity, flexibility, and customer
satisfaction. For services, both quantity and delivery involve a large “human component”
that affects costs, productivity, flexibility, and customer satisfaction. Variability of supply,
production, and demand complicate forecasting, planning, and inventory control. Despite
differences between goods and services, opportunities exist to apply basic supply management principles to the acquisition of services.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
joh77899_ch08_198-230.indd 226
Of what interest is ABC analysis?
What is a master production schedule and what role does it perform?
Why is it expensive to carry inventories?
In a typical fast-food operation, identify various forms and functions of inventory.
How could total investment in inventories be lowered? What might be the potential
consequences?
What are decoupling inventories?
What is a kanban and why is it used?
What problems do inaccurate usage forecasts create for buyers? For suppliers?
What is the difference between JIT and MRP?
Why would anyone prefer to use a fixed-period reordering model over a fixed-quantity
one?
How does intangibility of services affect quantity decisions?
Describe sources of variability in the supply chain. How does variability increase supply
chain costs?
6/9/10 9:48 PM
Chapter 8
References
Quantity and Inventory 227
Davis, M. M.; and J. Heineke. Operations Management: Integrating Manufacturing and
Services. 5th ed. New York: McGraw-Hill/Irwin, 2004.
Lambert, D. M.; J. R. Stock; and L. M. Ellram. Fundamentals of Logistics Management.
Burr Ridge, IL: McGraw-Hill/Irwin, 1998.
Nelson, D.; P. E. Moody; and J. Stegner. The Purchasing Machine: How the Top Ten
Companies Use Best Practices to Manage Their Supply Chains. New York: The Free
Press, 2001.
Ritzman, L. P.; L. J. Krajewski; and M. K. Malhotra. Operations Management. 9th ed.
Toronto: Pearson Prentice Hall, 2010.
Womack, J. P., and D. T. Jones. “From Lean Production to the Lean Enterprise.” Harvard
Business Review 27, no. 2 (1994), pp. 93–103.
Case 8–1
Sedgman Steel
Alice McKenzie, the production material control supervisor at Sedgman Steel in Syracuse, New York, sat at her
desk preparing for a meeting with her boss, Isaak Theissen.
Isaak, the director of materials management at Sedgman,
was concerned about the large amount of raw material inventory and had asked Alice earlier in the week to investigate the situation. It was now Wednesday, August 17, and
Alice had promised to provide a preliminary report to Isaak
on Friday afternoon.
COMPANY BACKGROUND
Sedgman Steel Inc. was a large diversified North America–
based manufacturing company, with annual sales of approximately $1.7 billion. The Syracuse operation employed
125 people and supplied cut-to-length steel tubing and steel
sheets to automotive and automotive parts companies.
Customers provided Sedgman with the specifications for the material, which included the chemical
composition (e.g., carbon content) and material thickness. Cut-to-length tubing specifications included inner
and outer diameter conditions. Raw material was supplied from one of two sources. Integrated steel companies supplied large steel coils, which were placed in
leveling and straightening equipment and cut to length.
The sheets were stacked on wooden pallets, banded,
and shipped to customers, usually on a just-in-time
(JIT) basis.
joh77899_ch08_198-230.indd 227
Steel tubing was supplied from a Sedgman tube manufacturing facility in Michigan. Tubing arrived in standard
lengths of 24 feet and was cut to length on computercontrolled cutting equipment. Tubing was loaded on
customer-supplied containers and also shipped on a JIT
basis.
Steel purchasing was an important activity at Sedgman
Steel Inc., and for the most part was handled at the plant
level in the company. Steel and tubing purchases at the
Syracuse plant represented approximately $65 to $70 million each year, and the purchasing manager there worked
closely with sales to make sure that material costs were
properly reflected in selling prices. Customer contracts
were negotiated in spring each year.
MATERIAL CONTROL
The material control department was responsible for incoming and outgoing transportation, inventory control, production planning and scheduling, and customer order fulfillment. Overall, the Syracuse plant had a dozen customers,
to which it supplied approximately 350 different products.
Sedgman routinely dealt with about 15 steel suppliers, while
its sister plant in Michigan was the sole supplier of tubing.
Policy was to have raw material available at least two
weeks in advance of production. Raw material deliveries
also were scheduled to accommodate full truckload shipments of about 80,000 pounds.
6/9/10 9:48 PM
228 Purchasing and Supply Management
Three years prior, Sedgman had contracted its warehousing and transportation services to a third-party logistics organization, Fehr Logistics Company. Fehr was
responsible for providing inbound and outbound transportation services and managing the 50,000-square-foot
warehouse adjacent to the manufacturing facility.
The contract with Fehr specified staffing levels and
hours of operation and provided the supplier with a profit
based on a percentage of its total costs. After some initial
problems, management was generally satisfied with its
relationship with Fehr.
RAW MATERIAL INVENTORY
Isaak Theissen had become concerned regarding the large
amount of raw material inventory. Inventory records for July
indicated that there was approximately $20 million of inventory on-hand, and on Tuesday he had asked Alice to investigate, commenting that: “Our customers certainly don’t carry
this amount of inventory. Why should we? I want you to look
into the situation and see what we can do to fix it.”
Earlier in the day, Alice decided to pay a visit to the
warehouse and was surprised with what she saw. The
warehouse was completely full with coils of steel and
bundles of raw tubes. Several trailers were parked outside
waiting to be unloaded. In addition, there appeared to be
a shortage of staff at the warehouse. The normal complement was eight, but Alice only identified five people.
PREPARATION FOR THE MEETING
As Alice prepared for the Friday meeting, she made a list
of issues that she would have to address with Isaak. Based
on what she knew so far, Alice agreed that opportunities existed to reduce the amount of inventory, but Isaak
would want specific targets and the timing identified. Furthermore, he would also need assurances that the inventory levels could be reduced without affecting operations
or customer service.
Recognizing the importance of the project, Alice had
blocked off the next two days. She wondered what steps
she should take next.
Case 8–2
Throsel-Teskey Drilling
On Wednesday, June 12, Alison Burkett, purchasing manager at Throsel-Teskey Drilling Inc. (Throsel-Teskey) in
Phoenix, Arizona, met with John Dietrich, the company’s
president. He said: “I am getting pressure from the board
to address our inventory variance. It has been more than
seven months since the merger, and we are not getting
the synergies that we expected from purchasing. I know
our sales are slightly higher than we expected, but inventory levels are more than twice what we had forecasted in
our budget. Our new shareholder is irate—they expect a
25 percent return on their capital. I need you to come up
with a plan that I can share with our board at the meeting here in Phoenix next Thursday.” Alison got up from
her chair and responded to John, “I will get you a report
with my recommendations on Monday, so we can review
it before the meeting.”
THROSEL-TESKEY DRILLING
Throsel-Teskey was a mining services company that performed diamond drilling for underground and surface exploration. Based in Phoenix, Arizona, the company had
more than 600 employees and approximately 145 surface
joh77899_ch08_198-230.indd 228
and underground drilling rigs operating at sites in the United States, Canada, Mexico, and South America. The company’s customers were top-tier multinational and junior
mining companies involved in the exploration and production of copper, zinc, and gold. Approximately 75 percent of
the company’s drilling rigs operated at sites in the southwestern United States.
Diamond drilling was required at each stage of mining operations: exploration, development, and production.
Diamond core drilling utilized an annular drill bit with an
industrial-grade diamond crown to cut a cylindrical core
from solid rock. Core samples were extracted and analyzed to provide the mine operator with information about
the mineral deposit. Throsel-Teskey paid its drill teams
a base rate and an incentive bonus for achieving production targets. Production levels averaged 825 feet per week
for each drill team, but varied substantially depending on
conditions.
In the previous October, Throsel Drilling Inc. merged
with Teskey-Dean Drilling Inc. (Teskey-Dean), which had
its head office in Albuquerque, New Mexico. Both companies were approximately the same size with respect to total
sales; however, Teskey-Dean specialized in underground
6/9/10 9:48 PM
Chapter 8
drilling while Throsel’s focus had been in surface drilling.
Jongsma Equity Partners (Jongsma), a Chicago-based private equity firm, which owned Teskey-Dean, led the merger and financing of the transaction. John Dietrich, who had
been CEO of Throsel, was appointed the president and
CEO of the new company and operations were consolidated at Throsel’s facilities located in Phoenix. Although
Jongsma controlled Throsel-Teskey, John Dietrich maintained a substantial equity interest in the company.
Increases in commodity prices during the past two
years had resulted in substantial increases in demand for
drilling services as mining companies expanded output.
As a result, Throsel-Teskey was operating at full capacity. John commented about the current market for his
company’s services: “Our bottlenecks are equipment and
people. However, it is easier for me to buy more drilling
rigs than to find qualified drillers. The pay is good, but
it is hard work and it takes at least a year to get someone
fully trained.”
PURCHASING AND MATERIALS
MANAGEMENT
Alison Burkett headed the purchasing department at
Throsel-Teskey and was responsible for sourcing and materials management. She had worked for John in a similar
role at Throsel Drilling for approximately three years. Reporting to Alison was Ken Jenner, materials manager, and
Emerson Parrish, warehouse manager.
Alison estimated that Throsel-Teskey purchased $25
to $27 million in goods and services each year from approximately 400 suppliers. Major purchase categories—
rods and casing, drill bits and reaming shells, wireline and
drill parts (collectively referred to as “drilling supplies”)—
accounted for approximately one-half of the company’s
total spend. The Phoenix warehouse carried approximately
800 different stock keeping units (SKUs), across a variety of purchase categories, such as drilling supplies, tools,
safety supplies, parts and equipment, motors, and hydraulic oil. For example, the company stocked eight different
types of rods and five different types of diamond drill bits.
At the time of the merger the company purchased the
majority of its drilling supplies from three companies.
Subsequently, John and Alison negotiated a strategic sourcing agreement with a supplier, also located in Phoenix, who
became the primary supplier for drilling supplies in return
for a significant price discount. Implementation of the new
sourcing agreement started in April, and the transition was
expected to last six months. However, because of specific
needs for certain equipment and drilling applications,
joh77899_ch08_198-230.indd 229
Quantity and Inventory 229
Alison expected that it would not be possible to standardize completely with one supplier.
The Phoenix warehouse had been expanded and renovated recently to accommodate the increased volume created by the merger. Shelving, racks, and bins had been added
to store inventory. Ken Jenner was responsible for receiving, shipping, and inventory control at the Phoenix warehouse. Since the company’s inventory system had not been
updated since the merger, he physically reviewed inventory
levels in the warehouse each Thursday and provided Alison
with a written purchase requisition to replenish stock. In recent months Alison had noticed that several suppliers were
experiencing delivery problems and extending lead times
as a direct result of an overall increase in demand for diamond drilling services by mining companies.
Shipments to drilling sites from Phoenix were made
on a five-day schedule by an outside transportation service company. Site foremen faxed or e-mailed requests
for materials and supplies to Ken two days in advance of
the scheduled deliver run to their site. Ken supervised two
people whose duties included picking and packing orders
for the sites.
Employees were provided open access to the warehouse to obtain materials and supplies. Since several of
the drilling sites were within a four hour drive to Phoenix,
it was common for a foreman to arrive unexpectedly at the
warehouse to pick up supplies.
Emerson Parrish supervised the warehouse in Albuquerque, where the company repaired its drills and equipment. This facility had been the central warehouse for
Teskey-Dean prior to the merger.
CURRENT SITUATION
Completing the merger and integrating the two purchasing and materials management organizations had been an
exhausting process for Alison and the other members of
the organization. The business plan had savings built in
from volume discounts and consolidating purchases with
a limited number of suppliers. Overall inventories were
expected to decline as a result of consolidating inventory management at the Phoenix warehouse. However,
since the merger last October, sales had increased by approximately 40 percent while inventory levels had more
than doubled from premerger levels of $5.990 million to
$12.584 million in May (see Exhibits 1 and 2).
Alison commented on the current situation: “Our focus for the past seven months has been to keep the drill
teams running and consolidate inventory in Phoenix.
Part of the problem has been that I haven’t had time to
6/9/10 9:48 PM
230 Purchasing and Supply Management
EXHIBIT 1
Budget versus
Actual Results
EXHIBIT 2
Inventory by
Category and
Location
Month
Jan.
Feb.
March
April
May
Inventory Budget
4,976,613
5,007,262
5,098,347
5,090,657
5,186,393
Category
Rods and casings
Drill bits and reaming shells
Wireline
Drill parts
Parts for equipment
Other
Total
Phoenix
Albuquerque
1,149,500
0
275,000
0
550,000
0
1,210,000
671,000
275,000
385,000
1,430,000
396,000
$4,889,500
$1,452,000
scrutinize our purchases and inventory levels. The fact
that our information system is cumbersome and the inventory records are not up to date is also a problem. We
are putting in a new ERP system starting in August, but
I expect it will be early next year before we can start
joh77899_ch08_198-230.indd 230
Inventory Actual
9,643,700
10,165,100
11,834,900
12,040,600
12,584,000
Drill Sites
2,920,500
1,870,000
825,000
297,000
165,000
165,000
$6,242,500
Sales
4,616,411
5,293,460
6,254,323
6,212,472
6,050,000
Total
4,070,000
2,145,000
1,375,000
2,178,000
825,000
1,991,000
$12,584,000
to rely on accurate, timely data from our system. In the
meantime our new shareholder is putting a lot of pressure on John to do something about the inventory problem, and I need a plan that will keep them satisfied while
not compromising production.”
6/9/10 9:48 PM
Chapter Nine
Delivery
Chapter Outline
Logistics
Role of Logistics in the Economy
Role of Supply in Logistics
Transportation
Transportation Regulation and
Deregulation
Supply’s Involvement in Transportation
Transportation Modes and Carriers
Road
Rail and Intermodal
Pipelines
Air
Water
Radio Frequency Waves
Types of Carriers, Providers, and Service
Options
Types of Carriers
Transportation Service Providers
Specialized Service Options
Selection of Mode and Supplier
“Best Value” Delivery Decisions
Key Selection Criteria
FOB Terms and Incoterms
Rates and Pricing
Documentation in Freight Shipments
Expediting and Tracing Shipments
Freight Audits
Delivery Options for Services
Buyer Location versus Supplier Location
On-premise versus Off-premise/Web-based
IT Delivery
Transportation and Logistics Strategy
Organization for Logistics
Conclusion
Questions for Review and Discussion
References
Cases
9–1 Penner Medical Products
9–2 Andrew Morton
231
joh77899_ch09_231-252.indd 231
6/9/10 9:49 PM
232 Purchasing and Supply Management
Key Questions for the Supply Decision Maker
Should we
• Designate delivery mode and carrier, or let the supplier do it?
• Use FOB (free on board) origin or FOB destination terms, or some other designation?
• Outsource some or all of the logistics function to a third party?
How can we
• Develop an effective delivery strategy for goods and services?
• Identify value-added logistics services that will reduce our overall costs?
• Ensure that we attain the optimum mix of reliability, costs, and service from
delivery service providers?
Purchased goods must be transported from the point where they are grown, mined, or manufactured to the place where they are needed, when they are needed, with inventories held at a
minimum amount to ensure production and customer service. Purchased services must also
be delivered on time. Delivery of services often depends more on radio frequency waves and
the Internet than trucks, trains, and planes. No matter which mode of transport is involved,
on-time delivery is a critical element of both goods and services purchasing.
The emphasis on reducing costs and cycle times throughout supply chains highlights the
importance of inventory velocity. This increases the need for competitive transportation
and other logistics services as an alternative to maintaining costly inventories. Advances in
information technology, coupled with the speed of Internet communications, have greatly
enabled the flow of real-time information and the reduction of inventory throughout supply
chains. (Technology issues are addressed in Chapter 4.)
Management must decide if results will be better if some or all logistics tasks are performed in-house or outsourced. No matter who is responsible and where logistics tasks are
performed (e.g., in-house or outsourced), improved coordination of information and material flows can help to achieve economies of scale and economies of scope. (Outsourcing is
discussed in Chapter 5)
Decisions about how to assure on-time delivery are important due to the large number
of dollars involved in the movement of goods into and out of an organization and the potential effect on profits. Two key decisions are addressed in this chapter: (1) How can we
assure on-time delivery at lowest total cost? and (2) What mode(s) of transportation and
supplier(s) should be selected for delivery?
LOGISTICS
Logistics is the management of inventory in motion and at rest. Logistics is defined by the
Council of Supply Chain Management Professionals (CSCMP) as “that part of the supply chain that plans, implements, and controls the efficient, effective flow and storage of
goods, services, and related information from the point of origin to the point of consump1
tion in order to meet customers’ requirements.” Logistics costs can be divided into three
1
joh77899_ch09_231-252.indd 232
CSCMP Supply Chain Management Definitions, http://cscmp.org/aboutcscmp/definitions.asp
6/9/10 9:49 PM
Chapter 9 Delivery
233
categories—inventory carrying costs, administrative costs, and transportation—with
transportation accounting for the bulk of the costs. Inventory was discussed in Chapter 8.
Transportation is covered in this chapter.
Role of Logistics in the Economy
Logistics activities are a vital part of economies. Total business logistics costs in the United
States in 2008 were estimated at $1.34 trillion down from $1.4 trillion in 2007, the first
decline since 2003. These costs were divided into inventory carrying costs, transportation
costs, and administrative costs. While this is an impressive amount, business logistics costs
in the United States have actually been declining over the past two decades as a percentage
of gross domestic product (GDP). Logistics costs as a percentage of U.S. GDP dropped to
9.4 percent from 10.1 percent in 2007, and from a high of 16.2 percent in 1981.2
A number of factors have contributed to declining logistics costs, including deregulation of the transportation sector, technology advances and e-commerce, and greater emphasis in organizations on improving supply chain processes and practices. More recently, the
global recession has severely affected the logistics industry.
Role of Supply in Logistics
Supply plays a vital role in delivery of goods and services in the supply chain. Supply may
have direct functional responsibility for some logistics responsibilities, such as arranging in-bound transportation with suppliers or responsibility for supervising warehousing
and stores. Meanwhile, others in the organization, such as marketing, may turn to supply
to assist in establishing relationships with third-party logistics (3PL) service providers to
operate distribution facilities and warehouses. Consequently, supply’s role in delivery can
involve functional oversight and logistics services acquisition. (Also see Chapters 3 and 16
for more information about the role of supply in logistics.)
The purchase of logistics services demands a high degree of skill and knowledge if
the costs of movement are to be minimized while at the same time meeting service needs.
Due to the complexity of the logistics industry and the significantly larger number of alternatives available as a result of deregulation, getting the best value for an organization’s
transportation and logistics dollar involves much more than simply “getting the best rate.”
TRANSPORTATION
Transportation accounts for the majority of logistics costs. Depending on the type of goods
being moved, transportation may account for as much as 40 percent of the total cost of
the item, particularly if it is of relatively low value, bulky, and heavy, such as agricultural
commodities or construction materials. But in the case of very-high-value low-weight and
low-bulk electronics goods, transport costs may be less than 1 percent of total purchase
costs. It is not unusual in many firms to find that a significant percent of their purchase
expenditures go for transportation costs. While target savings vary from firm to firm, many
have found that only a modest effort to manage transportation services more efficiently will
result in substantial savings.
2
joh77899_ch09_231-252.indd 233
R, Wilson, 20th Annual State of Logistics Report, June 17, 2009.
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234 Purchasing and Supply Management
If minimization of costs were the only objective in buying transportation services, the
task would be easy. However, the transportation buyer must look not only at cost but also
at service provided. For example, items are purchased to meet a production schedule, and
the available modes of transport require different amounts of transport time. If items are
shipped by a method requiring a long shipment time, inventory may be exhausted and a
plant or process shut down before the items arrive. Also, reliability may differ substantially
among various transportation companies or carriers; service levels, lost shipments, and
damage may vary greatly between two different carriers. The buyer should use the same
skill and attention in selecting carriers as used in selecting other suppliers. The effects of
transportation deregulation have made the carrier selection and pricing decision far more
important today.
In addition, just-in-time (JIT) purchasing systems (Chapter 8), global sourcing (Chapter 14), and outsourcing (Chapter 5) make logistics decisions more crucial. With JIT,
deliveries must be on time, with no damage to the items in transit, because minimal
inventories are maintained. Inventory cost savings should offset additional transportation costs from a supplier providing fast, reliable deliveries. When the transport buyer
is sourcing globally, extended lead times and distance place additional pressure on the
transport decision maker. The option to outsource some or all of the logistics function
also adds complexity to the analysis of options and the management of inventory at rest
and in motion.
With deregulation of the transportation industry and the development of intermodal
service, the focus for the transport buyer has shifted from mode of transport to breadth of
service, information systems, timeliness (reliability and speed), and rates. Breadth refers to
the ability of a carrier to handle multiple parts of the logistics process, including transportation, warehousing, inventory management, and shipper–carrier relationships.
Because of the importance of speed—in terms of both providing reliable, consistent,
on-time service and moving goods through the system quickly—shippers are seeking core
carriers with whom they can develop closer relationships to reduce cycle time. The development of information systems and the application of e-commerce tools to both inbound
and outbound transportation also contribute to timeliness and breadth of service. Shippers are demanding improved communications and information systems to facilitate order
tracking and expediting. Because delays in the supply chain may lead to higher inventory
levels and increased total cost, the whole logistics process is viewed as an area where cost
avoidance and cost reductions will reap bottom-line rewards.
Outsourcing, or using third-party logistics service (3PL) providers, has become increasingly popular as organizations downsize, focus on core competencies, and seek partnerships or alliances with key suppliers. The 3PL industry grew rapidly following deregulation
of the transportation sector. 3PLs provide a wide range of logistics services for their clients,
with the most popular being warehousing, outbound and inbound transportation, freight
bill auditing and payment, freight consolidation and distribution, cross-docking, product
marking, and packaging and returns.
Transportation Regulation and Deregulation
Government regulation in the transportation sector in both the United States and Canada
has been focused in two areas: economic and safety/environmental. For nearly 100 years,
the U.S. and Canadian transportation sectors operated under a strict regulatory environment
joh77899_ch09_231-252.indd 234
6/9/10 9:49 PM
Chapter 9 Delivery
235
that controlled rates, routes, carrier services, and geographic coverage. These economic
regulations were controlled at the federal, state, and provincial levels; and while government policies evolved over time, the objectives were to ensure that transport services were
available in all geographic areas without discrimination, establish rules for new forms of
transportation, provide market stability and supply, and control prices and services in the
face of monopoly power. Since the late 1970s, governments in Canada and the United
States and elsewhere in the world have embraced a policy and legislative agenda of deregulation. Today, the U.S. and Canadian transportation sectors are essentially deregulated,
with shippers able to negotiate rates, terms, services, and routes with service providers.
While economic regulations have been eliminated for the most part, carriers must adhere to an ever-increasing number and range of safety and environmental regulations, such
as transportation of dangerous goods, vehicle emissions, and working conditions. Government regulation also has established new standards for security at airports and ports since
the tragic events of 9/11. For example, the International Ship and Port Facility Code set new
standards for ship verification, certification, and control to ensure that appropriate security
measures are implemented.
As changes occur in the political, social, economic, and technological landscape, governments will continue to reassess transportation policies and regulations. Supply managers must keep abreast of actual and potential regulatory changes because of the potential
significant impact on the organization’s supply chain.
Supply’s Involvement in Transportation
Involvement of the supply function in transportation decisions is significant and growing
as a result of the added alternatives opened up by deregulation. Supply involvement is
in two areas. The first is direct functional responsibility within the organization for any
one or several logistical activities, such as transportation, warehousing, receiving, or inventory control. A 2004 study by CAPS Research found that in 284 large organizations,
inbound traffic reported to supply in 56 percent of the firms, compared to 51 percent
in 1995 and 40 percent in 1987. In the case of the outbound transportation function, it
reported to supply in 43 percent of the firms in 2003, which also was up from the 39 percent that reported to supply in 1995 and 31 percent in 1987.3
A second area of supply involvement is working with managers from other functions,
such as operations or marketing, in devising solutions with suppliers of logistics services to
improve customer service, lower costs, increase flexibility, or improve quality.
TRANSPORTATION MODES AND CARRIERS
The delivery decision includes three questions: (1) What mode of transportation is most appropriate for a specific order? (2) What carrier is the best? and (3) Which supplier offers the
best value? To answers these questions, the buyer must first understand modes and carriers.
A mode of transportation is the means by which people, freight, or information gain
mobility. The three basic means of mobility are land (road, rail, and pipeline), water,
and air. Radio frequency (RF) waves are a transportation mode that moves information
3
P. F. Johnson and M. R. Leenders, Supply’s Organizational Roles and Responsibilities (Tempe, AZ: CAPS
Research, November 2004).
joh77899_ch09_231-252.indd 235
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236 Purchasing and Supply Management
instantaneously. Transportation trends include integrating modes (intermodality) and linking modes more closely into supply chain activities of production and distribution.
A carrier transports property or people by any means of conveyance (truck, auto, taxi,
bus, railroad, ship, airplane), almost always for a charge. Carriers for RF waves are air
(wireless), copper wire, and fiber optic cable. Once a mode (for example land) of transportation has been selected, the buyer must decide on a carrier (e.g., railroad) and a specific
supplier (e.g., BNSF Railway).
Supply professionals need to understand the characteristics of each mode and carrier
in order to assess trade-offs when making transportation decisions. A brief description of
each follows.
Road
Motor carriers, or trucks, are the most flexible mode of transportation and account for approximately 80 percent of transportation expenditures by U.S. firms. This mode offers the
advantage of point-to-point service, over any distance, for products of varying weight and
size. Compared to other modes, service is fast and reliable, with low damage and loss rates.
Consequently, motor carriers are the preferred mode for organizations operating under a
just-in-time system.
Motor carriers can be divided into three categories: (1) less-than-truck-load (LTL), (2)
truckload (TL), and (3) small parcel, ground. LTL shipments are typically of short haul
compared to TL shipments, while the cost per hundredweight (cwt) is generally higher
compared to TL shipments over the same distance.
Rail and Intermodal
Rail carriers once dominated the transportation sector, but their share of the transportation
market has declined steadily since World War II. Rail carriers are relatively inflexible and
slow and have higher loss and damage rates, compared to motor carriers. However, rail has
the advantage of lower variable operating costs, which makes it attractive for hauling large
tonnage over long distances.
Intermodal freight services are divided between containers on flatcars (COFC) and
truck trailers on flatcars (TOFC), sometimes referred to as piggyback systems. This segment allows carriers to take advantage of the relative strengths of two modes. For example, shipments can benefit from the long-haul economies of rail, while accommodating
door-to-door service attributes of truck. Additional benefits include shorter terminal delays
and lower damage rates due to less handling. Since intermodal service was completely
deregulated, attractive arrangements often are possible, and growth in this mode has been
substantial.
Pipelines
Since pipelines can only transport products in either a liquid or gaseous state, the use of this
mode of transport is quite limited. However, once the initial investment in the pipeline is
recovered, the variable costs of operation are relatively low.
Air
The primary advantage of airfreight is speed. Airfreight is costly and also must be combined with trucks to provide door-to-door service. Consequently, products best suited for
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this mode are of high value and/or extremely perishable. Although airfreight volume has
increased over the past two decades, most shippers still regard this mode as premium emergency service.
Water
Although most international trade uses water carriers, referred to as international deep
sea transport, this mode is also used domestically in inland water and coastal systems and
lakes. Although inexpensive compared to other modes, water carriers are slow and inflexible. Similar to rail, waterway transportation is best suited for hauling large tonnage over
long distances and is frequently used for bulk commodities such as coal, grain, and sand.
Furthermore, compared to other modes, water carriers are disadvantaged because of the
need for suitable waterways, ports, and handling equipment. Water carriers also must team
up with motor carriers to provide door-to-door service.
Many waterway shipments involve the use of containers. Containers also can be transported via truck or rail from the point of origin to the final destination.
Radio Frequency Waves
Radio frequency (RF) waves are a mode of transportation for information. Carriers for
RF waves are air (wireless), copper wire, and fiberoptic cable. These telecommunication
routes transport information instantaneously. Growth comes from the increasing size of the
services sector of the economy, the increase in knowledge workers, and the importance of
information sharing in all types of organizations. For example, software may be delivered
via the Internet, and some movement of people may be replaced with information transport
(e.g., telecommuting).
Telecommunication routes are practically unlimited. Constraints from land and ocean
obstructions to laying cable are low. High network costs and low distribution costs characterize many telecommunication networks. Because radio frequency waves have limited
range, they require repeaters or substations, such as cellular towers, to transmit information
over distances. The limits on transmission speed and successful transmission come from
hardware, such as servers and modems, and software.
Communications satellites in geostationary orbit occupy a single ring (Clarke Orbit)
above the equator. Each satellite occupies a slot and requires a buffer of space to avoid
radio-frequency interference. This buffer limits the number of slots available. Conflicts
occur among densely populated countries at the same longitude (Americas, Europe/
Africa) that require the same orbital slots and radio frequencies. Superiority in the ability
to compress information gives a provider the advantage of transmitting more information
on the same bandwidth as a competitor. Resolution of decompressed information may be
a quality issue.
TYPES OF CARRIERS, PROVIDERS, AND SERVICE OPTIONS
While deregulation has reshaped the transportation sector, some terminology used to describe carriers is based on the legal designations under regulation. These are common carriers, contract carriers, exempt carriers, and private carriers. While these legal designations
technically no longer exist, they still provide guidance in terms of the role and function of
each group.
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Types of Carriers
Common carriers offer transportation service to all shippers at published rates, in a nondiscriminatory basis, between designated points. Under deregulation, however, common
carriers have considerable flexibility in establishing rates and routes.
A contract carrier is a for-hire carrier that provides service to a limited number of
shippers and operates under specific contractual arrangements that specify rates and
services. Generally, rates for contract carriers are lower than common carriers because
volumes are typically higher with individual shippers and scheduling is usually more
predictable.
Exempt carriers are also for-hire carriers, but they are exempt from regulation of rates
and services. This status was originally established to allow farmers to transport agriculture
products on public roads, but this status has been broadened over the years to include a
number of different products by a variety of modes. Under deregulation, most carriers can
be considered exempt from rate restrictions.
A private carrier provides transportation for its company’s own products and the company owns (or leases) all related equipment and facilities. In a regulated environment,
private carriers had the advantages of not being restricted by regulations and the flexibility
that this status offered. Today, common and contract carriers enjoy the same flexibility and
many companies have chosen to outsource transportation services as a result.
Transportation Service Providers
There are a number of transportation service providers, including freight forwarders, brokers, and customs house brokers.
Freight forwarders buy dedicated space on scheduled carriers. The benefits are lower
rates than the shipper might otherwise receive and one point of contact for shipments that
may span two or more modes and carriers. Freight forwarders can specialize as domestic
or international, or by mode, such as airfreight or surface transportation. Freight forwarders can provide a number of value-added services. For example, domestic surface freight
forwarders consolidate small shipments into rail cars and piggyback trailers and arrange
for motor carrier pickup and delivery.
Brokers charge shippers a fee for arranging transportation services with a carrier. The
broker will act as the shipper’s agent in negotiating rates and service arrangements. In
instances where the shipper has limited familiarity with the transportation market and
carrier options, brokers can provide the necessary expertise to oversee negotiations with
carriers.
Customs house brokers are used for importing products. They ensure that documentation is accurate and complete and can provide a variety of other services, such as providing
estimates of landed costs, payments to foreign suppliers, and insurance options available
to shippers. These include expedited transportation, same-day service, freight forwarders,
brokers, and customs-house brokers. The role and function of each service is described
below.
Specialized Service Options
Expedited transportation refers to any shipment that requires pickup service and includes
a specific delivery guarantee. In the United States, this is typically less than five days.
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Shipments may move via domestic air, ground parcel, less-than-truckload, or air-export
services.
Under deregulation, competition for small-shipment services has become intense.
Buyers now can use some of the standard supply techniques, such as systems contracts,
aggressive negotiation, multiple sourcing, quotation analysis, target pricing, and supplier
evaluation, to get better purchasing arrangements with carriers. Competition is intense
among express carriers as they move to cross over into the heavy-lift air cargo market. The
emerging integrated carriers, those with their own aircraft like Federal Express and UPS,
are capturing a larger share of the market. Volume discounts, tracking systems, and ground
networks are the distinguishing factors.
Another growth area is same-day service, which is being developed by express carriers such as DHL, UPS, and Federal Express. The same-day niche is growing rapidly and
expanding into the international market. The users of same-day service range from the
entertainment, advertising, and legal industries to manufacturers. The same-day service
is used when the cost of not having a critical part or document is greater than the amount
spent on same-day service.
SELECTION OF MODE AND SUPPLIER
Normally, the buyer will wish to specify how purchased items are to be shipped; this
is the buyer’s legal right if the purchase has been made under any of the free-on-board
(FOB) origin terms (defined later in this chapter). If the purchaser has received superior past service from a particular carrier, it then becomes the preferable means of
shipment.
“Best Value” Delivery Decisions
As one would expect, shippers are most concerned that the carrier meet its delivery promises (deliver on schedule) without damaging the goods and at a competitive cost. On the
other hand, if the shipper has relatively little expertise in the transportation area and the
supplier has a skilled logistics department, it might be wise to rely on the supplier’s judgment in carrier selection and routing. Also, in a time of shortage of transport equipment
(e.g., railroad cars, trucks, or ocean freight), the supplier may have better information about
the local situation and what arrangements will get the best results. And, if the item to be
shipped has special dimensional characteristics requiring special rail cars, the supplier may
be in a better position to know what is available and the clearances needed for proper
shipment.
Each form of common carrier transportation—rail, truck, air, and inland water—has its
own distinct advantages for shippers in respect to speed, available capacity, flexibility, and
cost. Each mode also has inherent disadvantages. For example, comparing air with truck
transport, air has the advantage in terms of speed; truck transport can accommodate greater
volume and has lower rates and greater flexibility in terms of delivery points. The astute
buyer must recognize such advantages/limitations and arrive at the best value considering
the needs of the organization.
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Key Selection Criteria
After determining the mode (land, water, or air) and carrier (truck, rail, pipeline, ship, or
airplane), a specific supplier and specific shipment routing must be determined. The factors to be considered when selecting mode of shipment, carrier, and routing include the
following:
Required delivery time. The required date for material receipt may make the selection of
mode of shipment quite simple. If two-day delivery from a distant point is needed, the only
viable alternative probably is air shipment. If more time is available, other modes can be
considered. Most carriers can supply estimates of normal delivery times, and the purchaser
also can rely on past experience with particular modes and carriers. Time-definite services
are in demand as organizations focus on time-based competition and JIT inventory management systems.
Reliability and service quality. While two carriers may offer freight service between the
same points, their reliability and dependability may differ greatly. One carrier may (1) be
more attentive to customer needs; (2) be more dependable in living up to its commitments;
(3) incur less damage, overall, to merchandise shipped; and (4) in general be the best freight
supplier. The buyer’s past experience is a good indicator of service quality.
Available services. As the demand for third-party logistics services grows, shippers want
services like warehousing and inventory management in addition to transportation services. In addition, carriers and 3PLs may offer access to data that can be used to improve
inventory management practices or to provide better customer service.
Type of item being shipped. If the item to be shipped is large and bulky, a particular mode
of transportation may be required. Special container requirements may indicate only certain carriers that have the unique equipment to handle the job. Bulk liquids, for example,
may indicate railroad tank car, barge, or pipeline. Also, safety requirements for hazardous
materials may make certain carriers and routings impractical or illegal.
Shipment size. The postal service, and companies such as Federal Express and United
Parcel Service, or airfreight forwarders can move items of small size and bulk. Larger shipments probably can be moved more economically by rail or truck.
Possibility of damage. Certain items, such as fine china or electronics equipment, by their
nature have a high risk of damage in shipment. In this case, the buyer may select a mode
and carrier by which the shipment can come straight through to its destination, with no
transfers at distribution points to another carrier. It is part of the buyer’s responsibility
to ensure that the packaging of goods is appropriate for both the contents and mode of
transport.
Cost of the transport service. The buyer should select the mode, carrier, and routing that
will provide for the safe movement of goods, within the required time, at the lowest total
transport cost. Also, the buyer may make certain trade-offs in purchasing transportation,
just as trade-offs are made in selecting suppliers for other purchases.
Carrier financial situation. If any volume of freight is moved, some damages will be incurred, resulting in claims against the carrier. Should the carrier get into financial difficulty, or even become insolvent, collection on claims becomes a problem. Therefore,
the buyer should avoid those carriers that are on the margin financially. While in an era
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of deregulation there are many new entrants in the transportation industry, there also are
many exits, and the number of bankruptcies—combined with changes in the laws and regulations governing transportation—may cause shippers to receive undercharge bills years
after the service was provided.
Handling of claims. Inevitably, some damage claims will arise in the shipment of quantities
of merchandise. Prompt and efficient investigation and settlement of claims is another key
factor in carrier selection.
Private fleets. One alternative to a common carrier is private or leased equipment. A private carrier does not offer service to the general public. Many companies have elected to
contract for exclusive use of equipment; and some have established their own trucking fleet
with either company-owned or leased tractors and vans.
The use of a private fleet is a type of make-or-buy decision. Maintaining a private fleet
gives the firm greater flexibility in scheduling freight services. It can be economically
advantageous, but unless the equipment can be fully utilized through planned back-hauls
of either semifinished or finished goods, it may turn out to be more costly than use of the
common carrier system.
FOB Terms and Incoterms
The term FOB stands for free on board, meaning that goods are delivered to a specified point with all transport charges paid. There are several variations in FOB terms, as
Table 9–1 shows. Shipping terms and the responsibilities of buyer and seller in international contracts are covered by Incoterms (International Commercial Terms). Incoterms
were developed in 1936 by the International Chamber of Commerce. The next revision is
scheduled for release in 2011. (Incoterms are covered in more detail in Chapter 14.)
TABLE 9–1 FOB Terms and Responsibilities
FOB Term
Payment
Bears
Files
of Freight Freight Owns Goods Claims
Charges Charges
in Transit
(if any)
FOB origin, or FOB freight
collect
Buyer
Buyer
Buyer
Buyer
FOB origin, freight prepaid
FOB origin, freight prepaid
and charged back
FOB destination, freight
collect
FOB destination, freight
prepaid
FOB destination, freight
prepaid and charged back
FOB destination, freight
collect and allowed
Seller
Seller
Seller
Buyer
Buyer
Buyer
Buyer
Buyer
Buyer
Buyer
Seller
Seller
Seller
Seller
Seller
Seller
Seller
Buyer
Seller
Seller
Buyer
Seller
Seller
Seller
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Explanation
Title and control of goods
passes to buyer when
carrier signs for goods
at point of origin
Seller pays freight charges
and adds to invoice
Title remains with seller
until goods are delivered
Seller pays freight charges
and adds to invoice
Buyer pays freight charges
and deducts from
seller’s invoice
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The selection of the FOB point is important to the purchaser because it determines four
things:
1. Who pays the carrier.
2. When legal title to goods being shipped passes to the buyer.
3. Who is responsible for preparing and pursuing claims with the carrier in the event
goods are lost or damaged during shipment.
4. Who routes the freight.
It is incorrect to claim that FOB destination is always preferable because the seller pays the
transportation charges. Ultimately, the charges are borne by the buyer because they will
be included in the delivered price charged by the supplier. In effect, if the buyer lets the
supplier make the transportation decisions, then the buyer is allowing the supplier to spend
the buyer’s money.
In purchases from international suppliers, FOB is an Incoterm meaning free on board
(named port of shipment), and the seller passes title to the goods to the buyer when the
goods are passed over the rail of the ship. The ocean carrier typically does not provide any
insurance on goods in transit; therefore, it is important, when goods are bought FOB origin,
for the buyer to ensure that adequate insurance coverage is provided.
The two marine freight terms commonly used are CFR and CIF. CFR (cost and freight)
is similar to FOB origin, with freight charges paid by the seller. However, under CFR the
buyer assumes all risk and should provide for insurance. CIF (cost, insurance, and freight)
means that the seller will pay the freight charges and provide appropriate insurance coverage. This is similar to FOB destination, freight prepaid. In some instances, the buyer
may wish to obtain equalization of freight charges with the nearest shipping point of the
seller, or some competitive shipping point. Then the following clause can be used: “Freight
charges to be equalized with those applicable from seller’s shipping point producing lowest transportation cost to buyer’s destination.” For a more detailed discussion of Incoterms,
see Chapter 14.
Rates and Pricing
The economic realities of transportation costs can be summarized succinctly. Transportation costs increase as distance, quantity, and speed increase. These realities are reflected in
the carrier’s rates and pricing arrangements.
The two categories of carrier rates are line haul rates and accessorial rates. Line haul
rates are charged for moving products to a nonlocal destination and can be grouped into
four categories: (1) class rates, (2) exception rates, (3) commodity rates, and (4) miscellaneous rates. Accessorial rates are charges for services not included in the negotiated line
haul rate. These may include fuel surcharges, Sunday pick-up or delivery, or loading and
unloading. Today, most rates between shippers and carriers are negotiated, and the distinctions between rate classifications have become blurred.
As with other purchases, carriers offer lower rates if the quantity of an individual shipment is large enough. Both rail and motor carriers offer discounts for full carload (CL) or
truckload (TL) shipments. These will be substantially less per hundred weight (cwt) than
less-than-carload (LCL) or less-than-truckload (LTL) quantities. If the shipper can consolidate smaller shipments to the same destination, a lower rate may be available (called a pool
car). In some instances, shippers may band together through a shippers’ association to get
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pool car transport rates. Or a redistributor may consolidate LTL shipments from multiple
customers to gain the advantages of a TL shipment. Shippers pay less than they would for
an LTL shipment and the redistributor can still make a profit.
The unit train is another innovation by which the shipper gets a quantity discount. By
special arrangement with a railroad, a utility company, for example, is provided one or
more complete trains, consisting of 100-plus coal cars, that shuttle between the coal mine
and the utility’s place of use. This speeds up the movement and the materials are moved at
an advantageous commodity rate.
Four basic types of rate discounts have developed; the buyer in some instances can take
advantage of one or more of them and possibly enjoy substantial savings.
1. Aggregate tender rates provide a discount if the shipper will group multiple small shipments for pickup or delivery at one point.
2. Flat percentage discounts provide a discount to the shipper if a specified total minimum weight of less-than-truckload shipments is moved per month, encouraging the
shipper to group volume with one carrier.
3. Increased volume–increased discount percentage is applied if a firm increases its volume of LTL shipments by a certain amount over the previous period’s volume.
4. Specific origin and destination points provide a specified discount if volume from a
specified point to a specified delivery point reaches a given level.
Demurrage charges (sometimes also called detention charges for motor carriers) often
are incurred by shippers or receivers of merchandise. This simply is a daily penalty charge
for a rail car or a motor van that is tied up beyond the normal time for loading or unloading. If demurrage were not charged, some firms would use the carrier’s equipment as a free
storage facility. In most instances, the daily demurrage rate becomes progressively higher
the longer the car or trailer is tied up, until it gets almost prohibitive. A shipper can enter
into an averaging agreement with a carrier, whereby cars or vans unloaded one day early
may be used to offset cars that are unloaded a day late. In an averaging agreement, settlement is made monthly. If the shipper owes the carrier, payment must be made; if the carrier
owes the shipper, no payment is made, but instead the net car balance starts at zero in the
new month. The supply department should be aware of the normal number of rail cars or
vans that can be unloaded each day and attempt to schedule shipments in so that they do
not “back up” and result in payment of demurrage penalties.
Documentation in Freight Shipments
There are several kinds of documents used when shipping products.
The bill of lading is the key document in the movement of goods. It contains information
about the products being shipped including weight and quantity, the origin of the shipment,
contract terms between the carrier and shipper, and the final destination. Each shipment must
have a bill of lading, which is the contract, spelling out the legal liabilities of all parties, and
no changes to the original bill of lading can be made unless approved by the carrier’s agent
in writing on the bill of lading. Signed by both the shipper’s and carrier’s agents, the bill of
lading is proof that shipment was made and is evidence of ownership. It is a contract and
fixes carrier liability; normally it will be kept by the party that has title to goods in transit,
for it must be provided to support any damage claims. As with most other documentation,
electronic versions and online systems management are common in many organizations.
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There are several variations on the bill of lading.
Uniform straight bill of lading. This is the complete bill of lading and contains the complete contract terms and conditions. The straight bill of lading–short form contains those
provisions uniform to both motor and rail. Short bills are not furnished by carriers but
instead are preprinted by shippers.
Unit bill of lading. This is prepared in four copies; the extra copy is the railroad’s waybill. This waybill moves with the shipment and may be of assistance in expediting freight
movement. A digital waybill is the electronic version.
Uniform order bill of lading. This is printed on yellow paper (the other bills of lading
must be on white paper) and is called a sight draft bill of lading. It is a negotiable instrument and must be surrendered to the carrier at destination before goods can be obtained. Its
primary use is to prevent delivery until payment is made for the goods. To obtain payment,
the shipper must provide a sight draft, along with the original copy of the bill of lading, to
its bank; when the draft clears, the bank gives the bill of lading to the shipper, who then can
obtain delivery of the merchandise.
The freight bill is the carrier’s invoice for services provided. In addition to providing
the total charges for the shipment, the freight bill typically lists the origin and destination,
consignee, items, and total weight. Carriers are not obligated to extend credit to shippers
and freight bills can be prepaid or collect (e.g., freight charges paid upon arrival of the
shipment).
A shipper must provide its carrier with a detailed description, in writing, of any loss
or damage that occurs in a shipment. A freight claim is a document submitted to recoup
financial costs from shipment loss or damage. There is not a standard freight claim form,
but most of the information provided in the claim is available on the bill of lading.
The carrier’s liability for loss and damage varies depending on the service provided
and the contractual terms between the shipper and the carrier. Most freight claims must be
submitted within nine months of delivery (or reasonable delivery in the event of loss), but
the carrier contract terms could stipulate a different filing period.
If the merchandise is being shipped under any of the FOB origin terms, the buyer will
have to pursue the claim. If the shipment is FOB destination, the supplier must process the
claim, but because the merchandise is in the buyer’s hands, the buyer will have to supply
much of the information to support the claim.
Unconcealed loss or damage is referred to in situations when it is evident on delivery
that loss or damage has occurred. Such damage or loss must be noted on the carrier’s delivery receipt and signed by the carrier’s delivering agent. If this is not done, the carrier may
maintain that it received a “clear receipt” and not admit any liability. It is a good idea for
the receiving department to have a camera available, take one or more photos of the damaged items, and have them signed by the carrier’s representative.
In contrast, concealed loss or damage refers to situations in which merchandise is found
short or damaged after the container is opened. The unpacking should be discontinued,
photos should be taken, and the carrier’s local agent should be requested to inspect the
items and prepare an inspection report.
Concealed loss or damage claims often are difficult to collect because it is hard to determine whether the loss or damage took place while the shipment was in the carrier’s possession or whether it occurred before the shipment was delivered to the carrier.
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Expediting and Tracing Shipments
Expediting means applying pressure to a supplier, in this case the transportation carrier, in
an attempt to encourage faster-than-normal delivery service. The carrier often can and will
provide faster service to assist the shipper in meeting an emergency requirement, provided
such requests are made sparingly. Expediting should be done through the carrier’s general
agent and, if at all possible, the carrier should be notified of the need for speed as far in
advance of the shipment as possible.
Tracing is similar to follow-up, for it attempts to determine the status (location) of items
that have been shipped but have not yet been received and thus are somewhere within the
transportation system. Tracing also is done through the carrier’s agent, although the shipper may work right along with the carrier’s agent in attempting to locate the shipment. If
tracing locates a shipment and indicates it will not be delivered by the required date, then
expediting is needed.
With new technology tools, such as global positioning systems, Internet-based communications, and bar coding, tracing can be done faster and more accurately. Some carriers are
able to provide online freight information systems that include the ability to track shipment
status in real time.
Freight Audits
Under regulation, it was common practice to hire traffic consultants or rate sharks to
audit freight bills to uncover instances of overpayment to the carrier. Traffic consultants
usually worked on a contingency basis, receiving a fee as a percentage of the costs
recovered.
Today, with the ability of carriers to adjust fees based on market conditions and to
negotiate fee structures directly with the shipper, the role of freight auditors has changed
dramatically. It is common for firms to hire transportation consultants that handle a wide
range of activities including carrier selection, rates and discounts, and liability. Sometimes referred to as “nonasset-based” third-party logistics (3PLs) providers, they provide
many of the services of transportation brokers. They use a combination of a network of
service providers and computer programs that helps to identify opportunities to optimize
costs in the transportation network and take responsibility for billing accuracy. In contrast,
“asset-based” 3LPs focus on their dedicated service offering and typically have long-term
relationships with shippers for services such as transportation, warehousing and inventory
control, and fulfillment.
DELIVERY OPTIONS FOR SERVICES
Service delivery can be thought of along the same lines as the delivery of goods. Delivery involves modes, carriers, and suppliers. Services are intangible products, typically information and/or activities directed at people, buildings, or equipment. Some
services also include a tangible good. For example, lawyers provide legal services for
client firms that may include a document such as a contract, an airline’s kiosk provides check-in services and generates boarding passes for passengers, and an Internet
service provider offers information transmission services to users who may then print
output.
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The modes (means of a service gaining mobility) are people, equipment, and radio frequency waves. Carriers (means of service conveyance) are the different service categories:
For example, law firms are carriers of legal expertise, janitorial firms are carriers of cleaning expertise, and phone companies are carriers for information transmission. Suppliers
include all of the companies providing a specific service: For example, Verizon, AT&T,
and Sprint provide telecommunications services.
Innovation in services may come in the form of totally new services, or variations on a
service or how the service is delivered. Think about the delivery of music—downloading
music versus buying CDs. Depending on the content, an in-person meeting may be replaced
by a phone call, which may be replaced by an e-mail, which may be replaced by a text message. While there are serious considerations when selecting the mode and carrier, clearly
there are several options.
How a service is delivered offers opportunities to both buyer and supplier. Are airplanes,
trains, and cars the only carriers a consultant can use to enable the delivery of consulting
services? Might some of the service be delivered via RF waves carrying information that
travels through the modes of air (wireless) or land (copper wire or fiber optic cable)? To
what extent can online meetings, conference calls, e-mail, and texting be used to deliver
high-quality consulting services at a lower total cost?
Intermodality (using multiple modes of delivery) is also used in services delivery. For
example, a janitorial service provides people and equipment to clean a building. The people or service providers require a means of transportation to travel to the building; they then
require access to the building, which may be by way of a secured entry requiring keys, a
swipe card or an access code; and they require the cleaning equipment and supplies necessary to actually deliver the cleaning service.
Members of supply chains that produce tangible products link modes closer together in
production and distribution activities. These linking techniques are also used in the delivery
of services. For example, a curriculum development team that is spread out geographically
might use Web-based meetings, e-mail, and texting to replace or supplement face-to-face
meetings with subject matter experts, teachers, students, parents, and other stakeholders
through all phases of instructional design, delivery, assessment, and feedback. Even the delivery of the educational service may involve multiple modes and linkages: people—teachers
and students together in a classroom using Web-based materials (RF waves), an off-site
teacher communicating via the Web with students in one location accessing Web-based materials, or an off-site teacher and students in dispersed locations using Web-based materials.
Buyer Location versus Supplier Location
The nature and place of service delivery may have significant acquisition repercussions.
For example, if the delivery of the service occurs on the premises of the purchaser, the
contract agreement may have to address a number of provisions. For example, in construction or installation services, questions of security, access, nature of dress, hours of work,
applicability of various codes for health and safety, what working days and hours are applicable, and what equipment and materials are to be provided by whom are all issues that
need to be addressed as part of the contract.
On the other hand, when the service is provided on the supplier’s premises or elsewhere,
many of these concerns may not arise, provided the service is not directed at personnel of
the purchaser.
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247
On-premise versus Off-premise/Web-based IT Delivery
Technology issues were discussed in Chapter 4, “Processes and Technology.” How application software is delivered relates to this discussion of delivery options. On-premise
delivery means that a company purchases a software package; pays a licensing fee; and installs, operates, and maintains that software at the company location. The total cost of this
approach includes purchase price, licensing fee, and internal IT capability. Off-premise
application service providers (ASP) house the software in one location and multiple users
access it. For example, Gmail users are all accessing Google’s e-mail software from their
individual locations. The lower costs of this model enable smaller and medium-sized organizations to use software that might be prohibitively expensive to purchase.
TRANSPORTATION AND LOGISTICS STRATEGY
Every supply organization must deal with logistics and transportation. Purchased goods
must be transported to the purchaser’s facilities where they are stored prior to consumption. As recent study of Fortune 500 companies found that 68 percent of respondents gave
responsibility for transportation and logistics to supply.4 The changes in the regulatory environment of transportation, advances in information management systems, and the growing concern with managing both upstream (suppliers) and downstream (end customers)
in supply networks have brought rapid and continuous change to logistics management.
The same principles of effective purchasing and supply management for the acquisition of
goods can and should be applied to logistics services. Development of a transportation and
logistics strategy should include:
Value analysis of alternatives. A service requirement value analysis may turn up totally
adequate lower-cost transport arrangements.
Price analysis. Rates vary substantially and decisions should be made only after consideration of all possibilities. Competitive quotes should be obtained. Negotiation of big-ticket
transportation is possible.
Consolidation of freight, where possible. Volume discounts may reduce transport costs substantially. Systems contracts and blanket orders may be advantageous. If JIT purchasing is
in use or being implemented, consolidation of several JIT suppliers may be cost-effective.
Analysis and evaluation of suppliers. Carrier selection and evaluation systems can provide data needed for better decision making. Four areas to evaluate are (1) financial,
(2) management, (3) technical/strategic, and (4) relational, or overall corporate relationship
between carrier and shipper.
Reassessment of the possibilities of using different transport modes. This would include
using private trucking and intermodal transportation, such as piggybacking. The savings
often are substantial.
Development of a closer relationship with selected carriers. Data that enable better planning of transport requirements should be shared to take advantage of the specialized
knowledge of both buyer and carrier. A reduced carrier base and partnerships or logistics
alliances might be considered.
4
P. F. Johnson and M. R., Supply’s Organizational Roles and Responsibilities (Tempe, AZ: CAPS
Research, 2004).
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248 Purchasing and Supply Management
Cost analysis/reductions. Long-term contracts; partnerships; third-party involvement;
freight consolidation; demurrage; packaging; and service, quality, and delivery requirements offer opportunities for cost reductions.
Outsourcing, third-party logistics, contracting out. As organizations downsize, focus on
core competencies, and face time-based competition, the decision to contract with a company or several companies to provide complete logistics services should be considered.
Safety considerations. Safety issues may be related to downward pressure on driver’s income since deregulation, and to shipper demands that may result in shippers and carriers
agreeing to unrealistic, legally unattainable delivery schedules. These pressures may lead
to drivers falsifying log books to conceal violations of hours worked and miles driven, and
to accidents involving commercial vehicles. Avoidance of safety problems should be a key
element in the strategy.
Environmental factors. Growing concerns over clean air and water, the transport of hazardous materials, and fuel/energy consumption also must be taken into account.
ORGANIZATION FOR LOGISTICS
In many firms, especially larger ones, management has decided that it can improve customer service and reduce costs by outsourcing multiple logistics functions. Other large
firms have decided there are benefits to having a separate in-house logistics services department. This department has specialists in areas such as selection of carriers and routing,
expediting, packaging, and handling claims in the case of loss or damage to goods during
shipment.
In the very large firm, the logistics function may be specialized even further, based
on the purpose of shipment. For example, an automobile producer may have three separate departments: one concerned with incoming materials shipments, one making the
decisions on in-plant and interplant materials movement, and the third concerned with
the shipment of finished goods through the distribution channels to customers. In an
organization operating under the materials management concept, the transportation or
logistics manager may have responsibility for all types of materials movement. This
person must recognize that storage, handling, and shipping of raw materials and finished goods does not add value to the product. Instead, it is a key cost element in the
operation of the firm and should be managed to minimize costs, within the parameters
of needed service.
In the medium-sized and smaller organization, the number of logistics decisions may
not be large enough to warrant a full-time logistics specialist and the volume of business
may make outsourcing too costly. The buyer or supply manager may be responsible
for logistics decisions. In this case, the buyer must have enough knowledge to make
decisions on preferred free on board (FOB) terms, selection of carriers and routing,
determination of freight rates, preparation of necessary documentation, expediting and
tracing of freight shipments, filing and settling of claims for loss or damage in transit,
and payment procedures for transport services received. These decisions must be made
in light of their impact on other areas such as inventory levels, carrying costs, and the
use of capital.
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Chapter 9 Delivery
Conclusion
Questions
for
Review
and
Discussion
Transportation costs represent a significant expense at most organizations and, in a deregulated environment, there is a wide range of service options available. Not only do
logistics and transportation services represent a significant cost; they also affect customer
service levels through availability of products, investments in infrastructure such as warehouse networks and trucks, and responsibilities within the supply chain for activities such
as expediting and filing claims for loss or damaged goods.
Supply has a dual role in managing transportation and logistics activities. In many
companies, supply has functional responsibility for logistical activities such as inbound
transportation, warehousing, and packaging. Supply also is expected to work with others
in the organization, such as marketing and operations, in managing outsourced agreements
with third-party logistics suppliers. Astute supply managers, therefore, should be familiar
with the basic concepts of transportation and logistics in order to appreciate the implications of their decisions, such as arranging transportation of raw materials from suppliers
or negotiating logistics outsourcing contracts with a 3PL.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
References
joh77899_ch09_231-252.indd 249
249
How has transportation deregulation affected the purchase of logistics services?
What factors should be considered in selecting a mode of transportation? A carrier?
How do firms organize to handle the logistics function?
Why might an organization decide to outsource all or some of its logistics activities
to a third party?
What types of transportation damage might occur and how should each be handled?
What kinds of shipping needs are best met by a courier and why?
What are the use and significance of the bill of lading?
What does FOB mean? What variations are there in FOB terms?
Why should a buyer audit payments for freight purchases?
What strategies should be developed to effectively manage the logistics function?
How would logistics decisions be affected by a JIT purchasing arrangement?
Under what circumstances might a buyer prefer each of the following carriers: TL,
LTL, air, water, rail, intermodal?
What is the difference between on-premise and off-premise delivery of IT services?
What are the key issues when deciding how a service is delivered?
Ballou, R. H. Business Logistics Management. 5th ed. Upper Saddle River, NJ: Prentice
Hall, 2004.
Bowersox, D. J.; D. J. Closs; and M. B. Cooper. 3rd ed. Supply Chain Logistics
Management. New York: McGraw-Hill/Irwin, 2009.
Coyle, J. J.; E. J. Bardi; and C. J. Langley Jr. The Management of Business Logistics: A
Supply Chain Perspective. 8th ed. Toronto, Canada: Thomson, 2008.
Incoterms 2000. New York: International Chamber of Commerce (ICC) Publishing Inc.,
2000.
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250 Purchasing and Supply Management
Murphy Jr., P. R., and Wood, D. F. Contemporary Logistics. 9th ed. Upper Saddle River,
NJ: Prentice Hall, 2008.
Ramburg, J. ICC Guide to Incoterms 2000. New York: International Chamber of
Commerce (ICC) Publishing Inc., 2000.
Stock, J. R., and D. M. Lambert. Strategic Logistics Management. 4th ed. New York:
McGraw-Hill/Irwin, 2001.
Case 9–1
Penner Medical Products
Neil Bennett, warehouse manager at Penner Medical Products (Penner), in Rockford, Illinois, was concerned about
rising costs and delays associated with shipments arriving
from an important Canadian supplier. Ken McCallum, the
general manager, had asked Neil to look into the situation
and get back to him with recommendations. It was Monday, April 14, and Neil knew that Ken expected to see his
plan by the end of the week.
PENNER
Penner was a medical supplies distributor and retailer,
supplying small and medium-sized medical practices for
more than 50 years. Company sales were $30 million and
Penner employed approximately 120 people. Management
expected a 10 percent increase in sales over the following five years. Penner sold a wide range of products, such
as blood pressure gauges, tongue depressors, scalpels, and
specialized furniture. Customers could purchase products
either through Penner’s five retail locations, all of them
within a 200-mile radius of Rockford, or order directly
from its central warehouse. The company took orders from
customers either over the phone or through its Web site.
Although Penner was a family-owned business, retirement of key family members resulted in the hiring of several
professional managers to run the company. Ken McCallum
had been with the company for less than one year and was
anxious to exploit opportunities to improve profitability.
Penner’s main warehouse was a 30,000-square-foot
building, normally filled with merchandise in excess of
$2 million. The warehouse was staffed by a manager, two
receivers, two drivers for local deliveries to customers,
two shippers, and two stock pickers, one of whom was
joh77899_ch09_231-252.indd 250
also occasionally asked to drive the company’s two-ton
truck, the biggest delivery vehicle available. Warehouse
workers were paid an average of $15 per hour.
Neil Bennett started with Penner as a stock picker and
was able to progress though the organization as a result of
his effort and dedication. He was promoted to warehouse
manager eight months earlier.
STINSON DISTRIBUTION COMPANY
Rising costs and missed delivery dates from Stinson Distribution Company (Stinson), an important supplier in
Ontario, Canada, had been a concern for some time. A
medium-sized company, Stinson had a long-term relationship with Penner, supplying a wide variety of specialized
equipment for medical offices. Stinson produced highquality products and was Penner’s only supplier of this
equipment.
Missed delivery dates and incomplete orders from
Stinson were resulting in customer complaints and lost
sales. Furthermore, transportation costs were well over
budget and senior management viewed inventory levels
as excessive. The controller indicated to Neil that inventory holding costs were 15 percent.
Two days per week, Penner’s two-ton truck was sent to
Stinson, traveling across the border at Detroit. Under ideal
conditions, the one-way trip took 9 to 10 hours, and the
truck, although empty in the first leg of the trip, was typically fully loaded with approximately $15,000 in goods
on its way back to Rockford. The controller indicated that
the cost of operating the two-ton truck was $55 per hour,
including fuel, insurance, and administrative overhead.
Neil observed that fuel costs had increased dramatically
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Chapter 9 Delivery
lately. He had tried to share the trips to Ontario with other
local businesses to cut down transportation costs, but such
efforts had been sporadic.
Concerns regarding security since 9/11 had resulted in
delays at the Detroit border crossing, extending shipping
times and costs for Penner. The duration and timing of
delays at the border were highly variable and could last
anywhere from 30 minutes to several hours. Furthermore,
incomplete paperwork could add to these problems, since
customs officials had become very thorough when reviewing documentation. Neil estimated that approximately
25 percent of the goods from Stinson were delayed as a
result of paperwork problems.
The two-ton truck was also in demand to supply materials to Penner’s customers, making scheduling deliveries increasingly difficult. Neil had recently resorted to
251
using United Parcel Services (UPS) to handle rush orders from Stinson, with an appreciable cost premium.
He observed that: “At least UPS never messes up the
paperwork and gets the product here on time.” Penner
was also currently paying $1,000 per month to rent space
at a warehouse in Windsor used to prepare shipments to
cross the border.
EVALUATING OPPORTUNITIES
Neil recognized that his meeting with Ken McCallum was
still five days away but wanted to get started working on
the problem right away. Ken had indicated, “This problem
is costing us a lot of money every day we let it continue. I
want a plan in place at the end of the week that will convince me that the problem is going to get fixed quickly.”
Case 9–2
Andrew Morton
Andrew Morton, customs and traffic coordinator at the
Central Ontario University, in Toronto, had just received a
call from Melissa Downing, finance manager at Canadian
Marine Lines in Vancouver. It was April 3, and Melissa
informed Andrew that representatives from Transport
Canada had held up a shipping container because a university shipment from Shanghai had not been labeled and
documented in accordance with regulations stipulated
in the Transportation of Dangerous Goods Act. Andrew
was particularly concerned because there were a number
of other consignees of goods in the container, and he
recognized that he needed to act immediately to resolve
the situation.
CENTRAL ONTARIO UNIVERSITY
Central Ontario University was one of Canada’s largest
universities, with approximately 1,200 faculty and almost
25,000 students. Research was an integral part of the university’s mission, and most full-time faculty were engaged
actively in research projects.
Andrew Morton was the university’s customs and traffic coordinator, which was part of the university’s purchasing department. He was responsible for assisting faculty and staff with inbound and outbound transportation
arrangements, including domestic shipments, imports,
joh77899_ch09_231-252.indd 251
exports, internal equipment moving, and addressing of
claims for lost or damaged shipments. The university did
not have a central receiving facility for incoming freight,
and all shipments were delivered by the carrier directly to
the unloading dock of the building indicated on the order.
A formal university shipping procedure documented responsibilities of parties involved in each transaction, such
as the receiver, recipient, and document matcher.
THE BROMINE PENTAFLUORIDE
SHIPMENT
Six months earlier, Peter Goris, a faculty member in the
Department of Earth Sciences, placed an order for supply
of bromine pentafluoride (BrF5). Bromine pentafluoride
is a colorless to pale yellow liquid chemical that is highly
corrosive and reactive. It can be used as an oxidizer and
a fluorinating agent in making fluorocarbons. However,
breathing bromine pentafluoride fumes can cause kidney,
liver, and lung damage.
Peter was conducting advanced research that required
bromine pentafluoride of exceptional purity to be used in
his experiments. Using the university’s low-value purchase
order process, which allowed users to deal directly with
suppliers for purchases under $1,000, he placed an order for
bromine pentafluoride with Shouwu International Trading
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252 Purchasing and Supply Management
Company (Shouwu) in Shanghai, China, FOB destination, freight prepaid. Shouwu was selected because they
produced the chemical with the purity that Peter required.
When Peter placed his order, Shouwu’s sales representative, Haiyu Zhao, assured him that the shipment would
be sent in compliance with the international maritime law
and it would comply with Canadian regulations regarding
the transport of dangerous goods.
Andrew first became aware of the shipment on March
15, when he received a bill of lading from Shouwu that
indicated that shipment was expected to reach the Port of
Vancouver in early April. He was concerned that a declaration of dangerous goods did not accompany the bill
and the university could be held liable for any incidents
once it entered the country. Consequently, Andrew decided to call Melissa Downing at Canadian Marine Lines,
who would be handling the shipment in Vancouver. He
informed her of the dangerous nature of the shipment,
the shipper, the name of the vessel, the bill of lading
number, the shipping company in China, and the port of
origination. Andrew also prepared a package containing
the appropriate shipping labels and documents so that the
shipment could be legally transported from Vancouver to
the university.
Later that same day, Andrew called his contact at
Transport Canada, Sheryl Henderson, to inform her of
the situation. Sheryl indicated that Transport Canada’s
policy was to hold Canadian importers fully liable for
any and all violations of transport of dangerous goods
regulations, even if the fault lay with the shipper. She
expected that customs inspectors would isolate the container when it arrived and that the shipment could be
delayed several days.
Peter was also able to get a copy of the invoice that
afternoon. He found that the order value was $7,650 and
it had been paid in full two months earlier.
Melissa contacted Andrew three days later to report
that over a teleconference that morning Haiyu Zhao had
claimed that the shipment was not hazardous but contained only common, nontoxic household chemicals.
Andrew now wondered if the shipment had been intentionally misrepresented.
joh77899_ch09_231-252.indd 252
ARRIVAL OF THE SHIPMENT
On April the 3rd, Andrew received a telephone message
from Melissa Downing that the container with the shipment of bromine pentafluoride had arrived and was being
isolated by Canada Customs inspectors. As Andrew had
feared, the shipment had been improperly identified on
the shipping documents by the shipper as a nonhazardous
substance. Melissa indicated that the container had begun incurring demurrage and handling costs, which were
$44.90 and $43.00 per day, respectively. Furthermore,
it appeared that there were other shipments in the same
shipping container, possibly foodstuff and personal items,
and there could be claims and other costs associated with
holding up these shipments.
Later that afternoon, Andrew received the following
e-mail from Melissa:
Andrew, I just received a call from one of the consignees
of goods in the container being held up in Vancouver due
to this shipment from China. The company is Kohlpec
Canada in Montreal and the contact person is Jason Kohl.
Apparently the goods they have in the container are for
Walmart, which plans to assess them a late penalty if the
shipment is delayed further. Walmart has also threatened
to cancel their next order. It is increasingly clear that you
may be sued for damages if we can’t get this problem
resolved. It looks like there are 21 consignees in the
container with our goods. Get back to me with how you
intend to handle this situation.
Andrew recognized that he had to take steps to remedy
the situation quickly. He felt that his earlier dealings with
Sheryl Henderson had gone well under the circumstances
and that she recognized that he had reacted in a responsible and timely manner.
As Andrew considered what could be done regarding the immediate situation, he also wondered what steps
could be taken to avoid similar problems in the future.
The director of purchasing, George Kerr, was aware of the
situation and had asked Andrew to implement appropriate
changes to the university’s purchasing and transportation
policies by the end of the month.
6/9/10 9:49 PM
Chapter Ten
Price
Chapter Outline
Relation of Cost to Price
Meaning of Cost
How Suppliers Establish Price
The Cost Approach
The Market Approach
Government Influence on Pricing
Legislation Affecting Price Determination
Types of Purchases
Raw Materials/Sensitive Commodities
Special Items
Standard Production Items
Small-Value Items
Capital Goods
Services
Resale
The Use of Quotations and Competitive
Bidding
Steps in the Bidding Process
Firm Bidding
Determination of Most Advantageous Bid
Collusive Bidding
Public-Sector Bidding
The Problem of Identical Prices
Discounts
Cash Discounts
Trade Discounts
Multiple Discounts
Quantity Discounts
The Price-Discount Problem
Quantity Discounts and Source Selection
Cumulative or Volume Discounts
Contract Options for Pricing
Firm-Fixed-Price (FFP) Contract
Cost-Plus-Fixed-Fee (CPFF) Contract
Cost-No-Fee (CNF) Contract
Cost-Plus-Incentive-Fee (CPIF) Contract
Provision for Price Changes
Contract Cancellation
Forward Buying and Commodities
Forward Buying versus Speculation
Organizing for Forward Buying
Control of Forward Buying
The Commodity Exchanges
Limitations of the Exchanges
Hedging
Sources of Information Regarding
Price Trends
Conclusion
Questions for Review and Discussion
References
Cases
10–1 Cottrill Inc.
10–2 Coral Drugs
10–3 Price Forecasting Exercise
253
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254 Purchasing and Supply Management
Key Questions for the Supply Decision Maker
Should we
• Use competitive bidding as our principal means of price determination?
• Take advantage of a volume or cash discount offered by a supplier?
• Use forward buying?
How can we
• Spot and combat price fixing?
• Use the futures market to hedge the purchase of raw materials?
• Know when to allow price changes during a contract?
Determination of the price to be paid is a major supply decision. The ability to get a “good
price” is sometimes held to be the prime test of a good buyer. If “good price” means greatest value, broadly defined, this is true. Three key decisions are addressed in this chapter:
(1) What is the right price to pay? (2) What represents best value? and (3) How can we
assure we are paying the right price?
While price is only one aspect of the overall supply job, it is extremely important. The
purchaser must be alert to different pricing methods, know when each is appropriate, and
use skill in arriving at the price to be paid. There is no reason to apologize for emphasizing
price or for giving it a place of importance among the factors to be considered. The purchaser rightly is expected to get the best value possible for the organization whose funds
are spent.
While competitive bidding can be used for some purchases, purchasing in the commodities market requires a much different approach and buyer skill set. This chapter examines
how suppliers set prices and techniques that can be used to establish and adjust prices.
Chapter 11 complements the material covered in this chapter by addressing supplier cost
analysis and negotiation.
RELATION OF COST TO PRICE
Every supply manager believes the supplier should be paid a fair price. But what does “fair
price” mean? A fair price is the lowest price that ensures a continuous supply of the proper
quality where and when needed.
A “continuous supply” is possible in the long run only from a supplier who is making a
reasonable profit. The supplier’s total costs, including a reasonable profit, must be covered
by total sales in the long run. Any one item in the line, however, may never contribute “its
full share” over any given period, but even for such an item the price paid normally should
at least cover the direct costs incurred.
A fair price to one seller for any one item may be higher than a fair price to another or
for an equally satisfactory substitute item. Both may be “fair prices” as far as the buyer is
concerned, and the buyer may pay both prices at the same time.
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255
Merely because a price is set by a monopolist or is established through collusion among
sellers does not, in and of itself, make that price unfair or excessive. Likewise, the prevailing
price need not necessarily be a fair price, as, for example, when such price is a “black” or “gray”
market price or when it is depressed or raised through monopolistic or coercive action.
The supply manager is called on continuously to exercise judgment about what the “fair
price” should be under a variety of circumstances. In part, accuracy in weighing the various
factors that culminate in a “fair and just price” depends on capitalizing on past experience
and thorough knowledge of production processes and associated costs, as well as logistics
costs such as storage, transportation, and other relevant costs.
Meaning of Cost
Assuming this concept of a fair price is sound, what are the relationships between cost
and price? Clearly, to stay in business over the long run, a supplier must cover total costs,
including overhead, and receive a profit. Otherwise, eventually the supplier will be forced
out of business. This reduces the number of sources available to the buyer and may cause
scarcity, higher prices, less-satisfactory service, and lower quality.
But what is to be included in the term cost? At times it is defined to mean only direct
labor and material costs, and in a period of depressed business conditions, a seller may be
willing merely to recover this amount rather than not make a sale at all. Or cost may mean
direct labor and material costs with a contribution toward overhead. If the cost for a particular item includes overhead, is the latter charged at the actual rate (provided it can be determined), or is it charged at an average rate? The average rate may be far from the actual rate.
Most knowledgeable businesspeople realize that determining the cost of a particular
article or service is not a precise process. In manufacturing industries there are two basic
classifications of costs: direct and indirect.
Direct costs can be specifically and accurately assigned to a given unit of production.
For example, direct material is 10 pounds of steel or direct labor is 30 minutes of a person’s
time on a machine or assembly line. However, under accepted accounting practices, the
actual price may not be the cost included in determining direct material costs. Because the
price paid may fluctuate over a period of time, it is common practice to use a standard cost.
Some companies use the last price paid in the immediately prior fiscal period. Others use
an average price for a specific period.
Indirect costs are incurred in the operation of a production plant or process, but normally
cannot be related directly to any given unit of production. Some examples are rent, property
taxes, machine depreciation, expenses of general supervisors, data processing, power, heat,
and light. Indirect costs often are referred to as overhead. They may be fixed or variable.
Classification of costs into variable, semivariable, and fixed categories is a common
accounting practice and necessary for any meaningful analysis of price/cost relationships.
Most direct costs are variable costs because they vary directly and proportionally with the
units produced. For example, a product that requires 10 pounds of steel for one unit will
require 100 pounds for 10 units.
Semivariable costs may vary with the number of units produced but are partly variable
and partly fixed. For example, more heat, light, and power are used when a plant is operating
at 90 percent of capacity than when operating at 50 percent, but the difference is not directly
proportional to the number of units produced. In fact, there would be some costs (fixed) for
heat, light, and power if production were stopped completely for a period of time.
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256 Purchasing and Supply Management
Fixed costs generally remain the same regardless of the number of units produced. For
example, real estate taxes will be the same for a given period of time regardless of whether
one unit or 100,000 units are produced. Several accounting methods can be used to allocate
fixed costs. A common method is to apply a percentage of direct costs in order to allocate
the cost of factory overhead. Full allocation of fixed expenses will depend on an accurate
forecast of production and the percentage used. Obviously, as full production capacity is
reached, the percentage rate will decline.
Factory overhead often is based on some set percentage of direct labor cost because,
historically, labor represented the largest cost element. Although rarely true now, standard cost accounting often has not changed. Selling, general, and administrative expense
is based on a set percentage of total manufacturing cost. The following example illustrates
the typical product cost buildup in a manufacturing setting:
Direct materials
⫹ Direct labor
⫹ Factory overhead*
ⴝ Manufacturing cost
⫹ General, administrative,
and selling cost
ⴝ Total cost
⫹ Profit
ⴝ Selling price
$ 5,500
2,000
2,500
$10,000
1,500
$11,500
920
$12,420
*Factory overhead consists of all indirect factory costs, both fixed and variable.
Costs can be defined as dollars and cents per unit based on an average cost for raw material over a period of time, direct labor costs, and an estimated volume of production over a
period of time on which the distribution of overhead is based.
If this definition of cost is acceptable, then a logical question is: Whose cost? Some
manufacturers are more efficient than others. Usually all sell the same item at about the
same price. But should this price be high enough to cover only the most efficient supplier’s
costs, or should it cover the costs of all suppliers? Furthermore, cost does not necessarily
determine market price. A seller’s insistence that a price must be a given amount because
of costs is not justified. Goods are worth, and will sell for, what the market will pay.
Moreover, no seller is entitled to a price that yields a profit merely because the supplier
is in business or assumes risk. If so, every business automatically would be entitled to a
profit regardless of costs, quality, or service. A seller that cannot efficiently supply a market with goods that are needed and desired by users is not entitled to get a price that even
covers costs.
HOW SUPPLIERS ESTABLISH PRICE
Depending on the commodity and industry, the market may vary from almost pure competition to oligopoly and monopoly. Pricing varies accordingly. For competitive reasons,
most firms will not disclose how prices are set, but the two traditional methods are the cost
approach and the market approach.
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257
The Cost Approach
The cost approach means that price is a certain amount over direct costs, allowing for
sufficient contribution to cover indirect costs and overhead and leaving a certain margin
for profit. This provides the purchaser with opportunities to seek lower-cost suppliers, to
suggest lower-cost manufacturing alternatives, and to question the size of the margin over
direct costs. Negotiation, used with cost-analysis techniques, is a particularly useful tool.
The Market Approach
The market approach implies that prices are set in the marketplace and may not be directly
related to cost. If demand is high relative to supply, prices are expected to rise; when
demand is low relative to supply, prices should decline. This, too, is an oversimplification.
Some economists hold that large multinational, multiproduct firms have such a grip on the
marketplace that pure competition does not exist and that prices will not drop even though
supply exceeds demand.
In the market approach, the purchaser either lives with prevailing market prices or finds
ways around them. If nothing can be done to attack the price structure directly, it still
may be possible to select suppliers willing to offer nonprice incentives, such as holding
inventory, technical and design service, superior quality, excellent delivery, transportation concessions, and early warning of impending price and product changes. Negotiation,
therefore, may center on items other than price.
Many economists hold that substitution of like but not identical materials or products
is one of the most powerful forces preventing a completely monopolistic or oligopolistic
grip on a market. For example, aluminum and copper may be interchanged in a number
of applications. The aluminum and copper markets, therefore, are not independent of one
another. The purchaser’s ability to recognize these trade-offs and to effect design and use
changes to take advantage of substitution is one determinant of flexibility. Make or buy
(or outsource) is another option. If access to the raw materials, technological process, and
labor skills is not severely restricted, one alternative may be for an organization to make its
own requirements to avoid excess market prices.
Sometimes purchasers use long-term contracts to induce the supplier to ignore market
conditions. This may be successful in certain instances, but suppliers normally find ways
around such commitments once it becomes obvious that the prevailing market price is
substantially above that paid by their long-term customers.
GOVERNMENT INFLUENCE ON PRICING
The government’s role in establishing price has changed dramatically. The role of government has been twofold. The government can have an active role in determining prices by
establishing production and import quotas and regulating the ways that buyers and sellers
are allowed to behave in agreeing on prices. Because other governments are active in price
control and have, in a number of situations, created dual pricing for domestic use and exports, it is difficult to see how the U.S. and Canadian governments will be able to ignore
their position. Prices may be determined by review or control boards or by strong moral
suasion. They are likely to be augmented by governmental controls such as quotas, tariffs,
and export permits.
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Governments influence prices of utilities that offer common services, such as electricity
and water, and set prices on licenses and goods and services provided by government-run
organizations, such as postal services. Energy deregulation is still in its infancy but will be
an interesting and challenging area for purchasers to watch. The U.S. Postal Service also
is undergoing changes as it forges alliances with private-industry competitors. What these
changes will mean in terms of pricing and negotiation opportunities remains to be seen.
Legislation Affecting Price Determination
While there are differences in United States and Canadian laws related to pricing, both federal governments have taken an active interest in how a buyer and seller agree on a price.
United States
The government’s position largely has been a protective role to prevent the stronger party
from imposing too onerous conditions on the weaker one or preventing collusion so that
competition will be maintained.
The two most important federal laws affecting competition and pricing practices are the
Sherman Antitrust and Robinson-Patman acts. The Sherman Antitrust Act of 1890 states
that any combination, conspiracy, or collusion with the intent of restricting trade in interstate
commerce is illegal. It is illegal for suppliers to get together to set prices (price fixing) or
determine the terms and conditions under which they will sell. Buyers cannot get together
to set the prices they will pay.
The Robinson-Patman Act (Federal Anti-Price Discrimination Act of 1936) says that a
supplier must sell the same item, in the same quantity, to all customers at the same price. It is
known as the “one-price law.” Some exceptions are permitted, such as a lower price (1) for
a larger purchase quantity, providing the seller can cost justify the lower price through cost
accounting data; (2) for moving distress or obsolete merchandise; or (3) for meeting the
lower price of local competition in a particular geographic area. It is also illegal for a buyer
knowingly to induce or accept a discriminatory price. However, the courts have held that it
is the buyer’s job to get the best possible price and as long as a buyer does not intentionally
mislead the seller into giving a more favorable price than is available to other buyers of the
same item, the law is not being violated.
A buyer can file a charge detailing the alleged violation to the Federal Trade Commission (FTC), which investigates alleged improprieties. Bringing a seller’s actions to the
government’s attention has few advantages for a buyer. Typically, the government’s reaction is relatively slow; the need for the item may be gone and conditions may be substantially changed by the time the complaint is decided. Most sellers view a complaint as an
unfriendly act, making it difficult to maintain a reasonable future relationship with that
particular supplier. For this reason, complaints are not common, and most are lodged by
public buying agencies rather than corporations.
Canada
Canadian federal pricing legislation differs from U.S. legislation, but it has essentially the
same intent. It prohibits certain pricing practices in an attempt to maintain competition in
the marketplace and applies to both buyers and sellers. Violation of the statute is a criminal
offense. Suppliers or buyers may not “conspire, combine, agree, or arrange with another
person” to raise prices unreasonably or to otherwise restrain competition. It does not prevent the exchange of data within a trade or professional association, providing it does not
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lessen price competition. Bid rigging is a per se violation, which means that the prosecution need only establish the existence of an agreement to gain a conviction; there is no
requirement to prove that the agreement unduly affected competition. It is also illegal for
a supplier to grant a price concession to one buyer that is not available to all other buyers
(similar to the U.S. Robinson-Patman Act).
Quantity discounts are permitted, as are one-time price cuts to clear out inventory. As in
the United States, the Canadian buyer who knowingly is on the receiving end of price discrimination also has violated the law. With regard to price maintenance and the purchase
of goods for resale, it requires that a supplier should not, by threat or promise, attempt to
influence how the firms that buy from it then price their products for resale.
TYPES OF PURCHASES
Analysis of suppliers’ costs is by no means the only basis for price determination. What
other means can be used? Much depends on the type of product being bought. There are
seven general classes:
1. Raw materials. This includes sensitive commodities, such as copper, wheat, and crude
petroleum, but also steel, cement, and so forth.
2. Special items. This includes custom-ordered items and materials that are special to the
organization’s product line.
3. Standard production items. This includes nuts and bolts, many forms of commercial
steel, valves, and tubing, whose prices are fairly stable and are quoted on a basis of “list
price with some discount.”
4. Small-value items. This includes items of small comparative value. Effort to check
price prior to purchase is not justified. Maintenance, repair, and operating supplies
(MRO) fall in this class.
5. Capital goods. Capital assets are long-term assets that are not bought or sold in the regular course of business, have an ongoing effect on the organization’s operations, have
an expected use of more than one year, involve large sums of money, and generally are
depreciated. Assets may be tangible or intangible. Historically, tangible assets (land,
buildings, and equipment) have been the primary focus of managerial attention because
they were the key drivers of wealth. Today, intangible assets (patents, copyrights, ideas,
knowledge, and people) are important generators of wealth. Intangible assets are especially challenging because traditional accounting procedures do not include valuation
methods for intangibles.
6. Services. This category is broad and includes many types of services, such as advertising, auditing, consulting, architectural design, legal, insurance, personnel travel, copying, security, and waste removal. The Cottrill case in this chapter provides an example
of a supplier selection decision that involves the acquisition of a paging service.
The final type of purchase, resale, is not discussed in detail here because it is outside
the scope of this text.
7. Resale. This category can be subdivided into two groups:
a. Items that formerly were manufactured in-house but have been outsourced to a manufacturing supplier. For example, a major appliance maker markets a microwave
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oven but, instead of manufacturing the product, buys it under its own brand name.
The decision process for these items is the same as presented in this book.
b. Items sold in the retail sector, such as clothing sold in general-line department stores;
food sold through supermarkets; tools sold in hardware stores; and tires, batteries,
and accessories sold in gasoline/filling stations.
The dollar amount involved in the purchase of these resale items is tremendous.
The people who buy these items, merchandise managers, make their buying decisions based on what they think will sell. There is no detailed coverage of merchandise buying, although many of the same supply principles and practices apply.
Raw Materials/Sensitive Commodities
Raw materials and commodities are normally quoted at market prices, which fluctuate
daily. The price at any particular moment probably is less important than the trend of the
price movement. The price can be determined readily in most instances because many of
these commodities are bought and sold on well-organized markets. Prices are reported
regularly online and in print in many of the trade and business journals and on Web sites,
such as American Metal Market (AMM), Chemical Marketing Reporter, and The Wall
Street Journal. These quoted market prices can be useful in developing prices-paid evaluation systems and price indexes for use in price escalator clauses.
To the extent that quoted prices are a fair reflection of market conditions, the current
cash price is known and is substantially uniform for a given grade. Such published market
quotations usually are on the high side, and the astute buyer probably can get a lower price.
A company’s requirements for these commodities usually are sufficiently adjustable that
purchase can be postponed if there is a downward price trend.
While the price trend is of importance in the purchase of any commodity, it is particularly important for this group. Insofar as “careful and studious timing” is essential to getting the right price, both the type of information required as a basis for such timing and the
sources from which the information can be obtained differ from those necessary in dealing
with other groups of items. Commodity study research, discussed in Chapter 17, is particularly useful in buying these items.
Special Items
Special items include the large variety of purchased parts or special materials peculiar to
the organization’s end product or service. Make or buy is always a significant consideration
because of the proprietary nature of these items. Prices normally are obtained by quotation
because published price lists are unavailable. Subcontracts are common, and the availability
of compatible or special equipment, skilled labor, and capacity may be significant factors
in determining price. Because large differences may exist between suppliers in terms of
these factors and their desire for business, prices may vary substantially. Each product is
unique and may need special attention. A diligent search for suppliers willing and able to
handle such special requirements, including an advantageous price, may pay off handsomely.
Standard Production Items
The third group of items includes standard production items whose prices are comparatively stable and likely to be quoted on a basis of list-less-certain-discounts. This includes
a range of items commonly obtainable from multiple sources. The inventory problems are
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largely routine. Changes in price do occur, but they are moderate and far less frequent than
with raw materials. Prices usually are obtained from online or hard-copy catalogs or similar publications of suppliers, supplemented by periodic discount sheets.
Still price quotes should be examined carefully because annual dollar volume may be
high and price per unit may be worth attention. If the material has been regularly or recently purchased, an up-to-date price record and catalog file give information about potential and current suppliers and prices paid. This enables the buyer to order without extended
investigation. However, if the buyer thinks the information is incomplete, a list of available
suppliers can be assembled from supplier files, catalogs, the Internet, and other sources
and quotation requests issued. Online auctions (seller-initiated) or reverse auctions (buyerinitiated) are also used by some organizations to more efficiently purchase standard items
(see Chapter 4).
Sales representatives are good sources for current prices and discounts. Few manufacturers rely wholly on catalogs (online or hard copy) for sales, but follow up such material
with visits by their salespersons.
A sales representative may quote the buyer a price while in the buyer’s office, and
the buyer may accept by issuing a purchase order (PO). There likely will be no problem, although legally the salesperson probably doesn’t have agency authority, and the
offer made by the salesperson does not legally commit the selling company until it has
been accepted by an officer of the selling company. If the buyer wishes to accept such an
offer, and to know that the offer is legally binding, he or she should ask the salesperson
to furnish a letter, signed by an officer of the selling company, stating that the salesperson
possesses the authority of a sales agent (see Chapter 15).
Small-Value Items
The fourth commodities group, often referred to as maintenance, repair, and operating supplies (MRO), includes items of such small comparative value that they do not justify any
special effort to analyze price. Every supply department buys MRO items, yet they do not
justify a catalog file, even when such catalogs are available, nor do they represent enough
money to warrant requests for quotations. The pricing problem is handled in a variety of
ways; the following constitutes an excellent summary of these procedures.
As discussed in Chapter 4, MRO items may be procured through e-procurement systems. While the actual transaction is handled electronically, most of the advantages come
from applying good supply practices, such as consolidating and standardizing requirements and reducing the number of suppliers.
Other common practices include sending out unpriced orders and indicating on the
order the last price paid or buying on a cost-plus basis with suppliers who have the materials in inventory and then conducting price checks. Procurement cards allow internal
customers to purchase small-value items from designated suppliers. Perhaps a more effective way to buy items of small value, such as those included in the MRO group, is to
use the systems-contracting, vendor-managed inventory (VMI), and third-party supplier
techniques described in Chapters 4 and 8.
Typically, sources of supply for small-value items are local, and current prices often are
obtained online or by telephone or fax. Prices are included on the purchase order so they
become a part of the agreement. The most common practice is to rely on the integrity of the
suppliers and omit detailed price checking. The supply manager’s goal when purchasing
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small-value items is to minimize the cost of acquisition, that is the ordering process costs.
Spot-checking is often used to control prices for small-dollar items. Discovery of unfair or
improper prices is a reason for discontinuing the source of supply.
Similar to the small-value purchase problem is the emergency requirement. For example,
with equipment breakdown, time may be of much greater value than money, and the buyer
may wish to get the supplier started immediately even though price has not been determined.
The buyer may decide merely to say “start” or “ship” and issue an unpriced purchase order.
If the price charged on the invoice is out of line, it can be challenged before payment.
Capital Goods
As addressed in Chapter 6, “Need Identification,” capital goods include equipment, IT,
real estate, and construction. Because of the high dollar amount and the long-term consequences of many capital projects, purchase price is often a small percentage of total
cost of ownership. The application of tools and techniques such as enterprisewide spend
analysis; standardization of equipment, including hardware and software; globalization of
processes; and cost visibility are important.
Services
Pricing in services may be fixed or variable, by the job or by the hour, day, or week. Prices
may be obtained by competitive bid if the size of the contract warrants it; enough competitors are available; and adequate, specific, consistent specifications can be prepared.
Negotiation is commonly used to establish prices and may be the only option in solesource situations. Volume and size can be used effectively as leverage by the knowledgeable supply manager. Understanding the cost structure of the service is helpful in revealing
negotiation opportunities.
It is not unusual to estimate professional time required without committing to a specific
figure. Most supply managers probably would prefer such contracts to have a “not to exceed limit.” Some professionals, such as architects, may quote their fee based on a percentage of the total job cost. But from a supply standpoint, this removes the incentive for the
architect to seek the best value for the total job.
Resale
Merchandise managers must determine a fair price to pay for resale items that allows both
the supplier and the merchandiser to make a profit. As discussed in Chapter 6, the largest
single cost for a reseller who takes ownership of the goods it resells is what it paid for the
goods or services. Although resale is not covered specifically in this text, many of the concepts and practices of price and cost management apply.
THE USE OF QUOTATIONS AND COMPETITIVE BIDDING
Quotations normally are secured when the size of the proposed commitment exceeds some
minimum dollar amount, for example, $1,000. Governmental purchases commonly must
be on a bid basis; here the law requires that the award shall be made to the lowest responsible and responsive bidder. In the private sector, organizations may solicit quotations and
negotiate the final price.
The use of competitive bidding for price determination varies widely. It is a common
practice for buyers of routine supplies, purchased from the same sources time after time, to
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issue unpriced orders. The same thing occasionally happens in a very strong seller’s market
for some critical item when prices are rising so rapidly that the supplier refuses to quote a
fixed price. Whenever possible, however, price should be indicated on the purchase order.
In fact, from a legal point of view, a purchase order must contain either a price or a method
of its determination for the contract to be binding. With competitive bids, the following are
required: a careful initial selection of dependable, potential sources; an accurate wording of
the request to bid; submission of bid requests to a sufficient number of suppliers to ensure a
truly competitive price; proper treatment of quotations, and a careful analysis prior to award.
Steps in the Bidding Process
The first step is to screen sources of supply and select potential suppliers from whom
quotations will be solicited. It is assumed that the bidders must (1) be qualified to make
the item in accordance with the buyer’s specifications and to deliver it by the desired date,
(2) be sufficiently reliable, (3) be numerous enough to ensure a truly competitive price,
but (4) not be more numerous than necessary. The first two issues were considered in our
discussion of sources. The number of suppliers to whom inquiries are sent is largely a
matter of the buyer’s judgment. Ordinarily, at least two suppliers are invited to bid. More
often, three or four are. Multiple bidders do not ensure a competitive price, although under
ordinary circumstances it is an important factor if bidders are comparable and each is sufficiently reliable and the buyer would purchase from them.
The buyer normally will exclude from the bid list those firms with whom it is unlikely to
place an order even though their prices are low. Sometimes bids are solicited solely for the
purpose of price checking or for inventory-pricing purposes. It costs a company to submit
a bid. Suppliers should not be asked to bear this cost without good reason. Moreover, the
receipt of a request to bid is an encouragement to the supplier and implies that an order
is possible. Therefore, purchasers should not solicit quotations unless placement of a purchase order is a possibility.
Off-line Process
After selecting the companies to be invited to bid, the purchaser in an off-line process sends
a general inquiry that includes a complete description of the item(s), the delivery date, and
the due date for bids. A telephone inquiry may be substituted for a formal request to bid.
Between mailing an inquiry and awarding the contract, bidders want to know how their
quotations compare with competitors. Because sealed bids, used in governmental purchasing, are not commonly used in private industry, the purchaser is in a position to know how
the bids, as they are received, compare with one another. However, if the bids are examined
on receipt, it is important that this information be treated in strictest confidence. Indeed,
some buyers deliberately keep quotations secret until they are ready to analyze the bids;
thus they are in a position to tell any inquiring bidder truthfully that they do not know how
the bid prices compare. Even after the award is made, it probably is the better policy not to
reveal to unsuccessful bidders the amount by which they failed to meet the successful bid.
Automated Process
In both the public and private sectors, the entire bid process may be automated. Bid packages and specifications are made available online, bidders submit their bids and proposals
online, and the bid opening and award are communicated electronically. The cycle time
reductions and other cost savings can be great if the automated process is efficient.
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This process is similar to an online bid. In an online auction, the potential sources are
prequalified and invited to participate. The auction, or event, is set for a specific date and
time period much like the deadline and bid opening deadlines in an off-line process. Auction success depends on the quality of the bid specifications and the ability of the person
and process to prequalify suppliers. Bidders can see, online, the actual bid amounts but not
who the bidders are. (See Chapter 4.)
Firm Bidding
Bid price information is treated confidentially because buyers often face “firm bidding.”
Most organizations have a policy of notifying suppliers that original bids must be final
(firm) and that revisions will not be permitted under any circumstances. Exceptions are
made only in the case of obvious error.
When prices are falling and suppliers need orders, suppliers try to ensure that their bids
will be the lowest. Frequently, suppliers are encouraged by purchasers who have acceded
to requests that revisions be allowed. Unfortunately, it is also true that there are buyers who
deliberately play one bidder against another and who even seek to secure lower prices by
relating imaginary bids to prospective suppliers. The responsibility for deviations from a
policy of firm bidding lies with the purchaser as well as the supplier.
A policy of firm bidding is sound and should be deviated from only under the most
unusual circumstances. This is the practice followed in many organizations. The advantage
of firm bidding as a general policy is that it is the fairest possible means of treating all suppliers alike. It tends to stress the quality and service elements in the transaction instead of
the price factor. Assuming that bids are solicited only from honest and dependable suppliers and that the buyer is not obligated to place the order with the lowest bidder, it removes
from suppliers the temptation to try to use inferior materials or workmanship once their
bid has been accepted. It saves the purchaser time by removing the necessity for constant
bargaining with suppliers over price.
An exception to the firm bidding approach is one in which the buyer wants both parties
(seller and buyer) to have the flexibility to clarify and define specifications and prices further after the initial bids are received. The buyer will notify all the sellers in the bid request
that, after the initial bids are received, the buyer may enter into discussions with one or
more of the bidders, and then request best-and-final-offers (BAFOs). Some public buying
agencies also use this approach.
Occasionally the buyer may notify bidders that all bids are being rejected and another
bid request is being issued, or that the item will be bought through a means other than
competitive bidding. This is done if it is obvious that the bidders did not fully understand
the specifications, if collusion on the part of the bidders is suspected, or if it is felt that all
prices quoted are unrealistically high.
Determination of Most Advantageous Bid
Typically, a bid analysis sheet arrays the bids or they are viewed electronically in real time
during an online auction. The lowest bid customarily is accepted. The objective of securing bids from various sources is to obtain the lowest price, and the purpose of supplying
detailed specifications and statements of requirements is to ensure receipt of the same items
or services from any bidder. Governmental contracts must be awarded to the lowest bidder
unless very special reasons can be shown for not doing so.
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Sometimes the lowest bidder may not receive the order. This occurs when the buyer
discovers that the lowest bidder is unreliable, the lowest bid is higher than the buyer believes justifiable, or there is reason to believe bidders colluded. Also, users such as plant
management, engineering, or marketing may prefer a certain supplier’s product. A slight
difference in price may not compensate for the confidence in a particular supplier’s product
or service, or satisfaction with a long-term supplier. Yet the bid process may be essential
in ensuring proper price treatment.
Selecting the supplier is not a simple matter of listing the bidders and picking out the
one whose price is apparently low, because the obvious price comparisons may be misleading. Of two apparently identical bids, one actually may be higher than the other. One supplier’s installation costs may be lower than another’s. If prices quoted are FOB origin, the
transportation charges may be markedly different. One supplier’s price may be much lower
because it is trying to break into a new market or is trying to force its only real competitor
out of business. One supplier’s product may require tooling that must be amortized. One
supplier may quote a fixed price; another may insist on an escalator clause that could push
the price above a competitor’s firm bid. These and other factors render a snap judgment on
comparative price a mistake.
The Coral Drugs case at the end of this chapter and the Carson Manor case in Chapter 6
are examples of organizations facing complex supplier selection decisions following a bidding process.
Collusive Bidding
A buyer also may reject all bids if it is suspected that the suppliers are acting in collusion
with one another. The proper policy is often difficult to determine, but there are various
possibilities. Legal action is possible but seldom feasible because of the expense, delay,
and uncertainty of the outcome. Often, unfortunately, the only apparent solution is to accept the situation because there is nothing the buyer can do about it anyway. Another possibility is to seek new sources of supply either inside or outside the area in which the buyer
customarily has purchased materials or services. Using substitute materials, temporarily
or permanently, may be an effective solution. Another possibility is to reject all the bids
and then try to negotiate with one supplier to reduce the price. If negotiation is the most
feasible alternative, a question of ethics is involved. Some supply managers believe that
supplier collusion means it is ethical for them to attempt to force down prices by means that
ordinarily would not be adopted.
Public-Sector Bidding
The process for bidding in the public sector is similar to the private sector, but there are
a few important differences. Public statutes normally provide that the award of purchase
contracts should be made on the basis of open, competitive bidding. The goal is to ensure
that all qualified suppliers who are taxpayers or who employ personnel who are taxpayers,
have an equal opportunity to compete for the sale of products or services needed to operate
government. Since bids are open to public inspection, it is difficult for the public buyer to
show favoritism to any one supplier. This system tends to put a heavy weight on price as
the basis for supplier selection because it might be difficult for the buyer to defend selecting a higher-priced supplier. Providing a list of weighted criteria for bid evaluations in the
invitation to bid allows the buyer to consider nonprice factors (see Chapter 13).
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Either by law, statute, or regulation or as a matter of normal operating policy, public
purchasers in North America and Europe are required to advertise upcoming purchases
in specified newspapers or online. The advertisement informs interested suppliers how to
access or receive a request for bid for a particular requirement. The buyer then determines
whether the supplier meets the minimum supplier qualifications. Advertising ensures that
purchasing is not conducted under a veil of secrecy.
The public buyer generally must be willing to consider any supplier who requests to
be put on the bid list, after suitable investigation. However, public purchasers should be
aggressive in ferreting out new potential supply sources. Public purchasers are required to
award contracts to the lowest “responsible” and “responsive” bidder. A responsible bidder
is fully capable and willing to perform the work; a responsive bidder submits a bid that
conforms to the invitation for bid.
In some public agencies, a purchase award cannot be made unless at least some minimum number of bids (often three) has been received. If the minimum number is not received, the requirement must be rebid, or the buyer must justify that the nature of the
requirement is such that it is impossible to obtain bids from more suppliers.
Use of Bid Bonds and Deposits
There may be a legal or policy requirement for bidders to submit a bond at the time of the
bid, especially for large-dollar bids or construction. Or the bidders are required to submit a
certified check or money order in a fixed percentage amount of the bid. If the selected bidder does not agree to sign the final purchase contract or does not perform according to the
terms of the bid, this amount is retained as liquidated damages for nonperformance. The
bid bond or bid deposit is designed to discourage irresponsible bidders from competing. In
high-risk situations, the extra cost of the bid bond, which in some way will be passed back
as an extra cost to the buyer, is warranted; in the purchase of standard, stock items available
from several sources, the use of a bond is questionable.
There are three general types of bonds. Most bidders purchase each, for a dollar premium, from an insurance company, thus effectively transferring some of the risk to the
insurance carrier:
1. The bid (or surety) bond guarantees that if the bidder wins it will accept the purchase
contract. If the supplier refuses, the extra costs to the buyer of going to an alternative
source are borne by the insurer.
2. The performance bond guarantees work will be done according to specifications and in
the time specified. If another supplier does rework or completes the order, purchasing
is indemnified for these extra costs.
3. The payment bond protects the buyer against liens that might be granted to suppliers of
material and labor to the bidder, in the event the bidder does not make proper payment
to its suppliers.
In a multiple-year contract or one with high initial costs, the purchaser may want to
break the performance bond into periods or stages of completion to avoid having the surety
write the bond too high and increase the cost of the contract too much.
Bid Opening, Evaluation, and Award
At the hour and date specified in the bid instructions, the buyer opens and records all bids.
Usually, any interested party can attend the bid opening and examine any of the bids. The
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original bids are retained for later inspection by any interested party for a specified time
period (often 12 months).
After the bid opening, the buyer analyzes the bids for conformance to bid requirements
and prepares a recommended purchase action. Large-dollar purchases may require council
approval in a municipality or cabinet approval for a federal or state procurement.
If multiple bid criteria apply and if two or more responsible bidders meet the
specifications and conditions, the supplier with the best rating is selected. Other actions
by the buyer must be justified. If identical low bids are received, and the buyer has no
evidence or indication of collusion or other bid irregularities, then the buyer must find an
acceptable way of resolving this issue.
The public buyer has no obligation to notify unsuccessful bidders because the bid opening was a public event and the bid and award documents are retained and may be viewed.
Bid Errors
If the successful low bidder notifies the buyer of an error after the bid has been submitted, but
before the award of the purchase order has been made, normally the bid may be withdrawn.
However, the buyer makes note of this, since it reflects on the responsibility of the bidder.
A much-more-serious problem arises if the bidder, claiming a bid error, attempts to
withdraw the bid after it has been awarded. A bid bond helps protect the buyer. If no bid
bond exists, the buyer must decide on court action to force performance or collect damages or go to the closest other successful bidder (who now may no longer be interested)
or go through the bid process again. Legally, if the mistake was mechanical in nature, a
mathematical error, the courts probably will side with the supplier. However, if it was an
error in judgment—for example, the supplier misjudged the rate of escalation in material
prices—then the courts generally will not permit relief to the supplier. Also, for the supplier to gain relief in the courts, the supplier must show that once the error was discovered,
the buying agency was notified promptly.
If the buyer receives a bid that commonsense and knowledge of the market indicates is
unrealistic, the bid should be rechecked and the bidder requested to reaffirm that it is a bona
fide bid. In the long run, such action likely will be cheaper than a protracted legal battle
with an uncertain outcome.
Competition Concerns
Since public purchasers share bid information with each other, they are in a unique position
to watch for illegal trade practices by suppliers. Collusion may be evident from artificially
high prices, identical prices, unwillingness to bid, the rotation of low bidder among a small
group of bidders, the apparent favoring of a particular bidder on a specific requirement
area, and so on. Every country has an agency or bureau that investigates anticompetitive
practices and prosecutes perpetrators. The antitrust division of the U.S. Department of
Justice and the Competition Bureau in Canada perform these tasks.
The Problem of Identical Prices
It is not unusual to receive identical bids from various sources. This may indicate intensive
competition or discrimination or collusion. Identical or parallel prices are suspect when:
1. Identical pricing marks a novel break in the historical pattern of price behavior.
2. There is evidence of communication between sellers or buyers regarding prices.
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3. There is an “artificial” standardization of the product.
4. Identical prices are submitted in bids to buyers on complex, detailed, or novel specifications.
5. Deviations from uniform prices become the matter of industrywide concern—the subject of meetings and even organized sanctions.
There are four types of action to discourage identical pricing. First, encourage small
sellers who form the nonconformist group in an industry and are anxious to grow. Second,
allow bids on parts of large contracts if bidders feel the total contract is too large. Third,
encourage firm bidding without revision. Fourth, choose award criteria that discourage
future identical bids.
If identical bids are received, the buyer can reject all bids and then either call for new
bids or negotiate directly with one or more specific suppliers. If the contract is going to be
awarded, it may be given to:
1.
2.
3.
4.
5.
6.
The smallest supplier.
The one with the largest domestic content.
The most distant firm, forcing it to absorb the largest freight portion.
The firm with the smallest market share.
The firm most likely to grant nonprice concessions.
The firm whose past performance has been best.
Competitive bidding is used to obtain a fair price; the forces of competition are used to
bring the price down to a level at which the efficient supplier will be able to cover only production and distribution costs, plus make a minimum profit. If a supplier wants the order,
that supplier will “sharpen the pencil” and give the buyer an attractive quote. This places a
good deal of pressure on the supplier.
Several conditions are necessary for the bid process to work efficiently: (1) There must
be at least two, and preferably several, qualified suppliers; (2) the suppliers must want
the business (competitive bidding works best in a buyer’s market); (3) the specifications must
be clear, so that each bidder knows precisely what it is bidding on, and so that the buyer can
easily compare quotes; and (4) there must be honest bidding and the absence of collusion.
When any of these conditions is absent—that is, a sole-source situation, a seller’s market,
specifications that are not complete or subject to varying interpretations, or suspected supplier
collusion—then negotiation is the preferred method of price determination. (See Chapter 11.)
DISCOUNTS
Discounts represent a legitimate and effective means of reducing prices. The most commonly
used types of discounts are cash discounts, multiple discounts, quantity discounts, and cumulative or volume discounts. They may be offered by suppliers or negotiated by purchasers.
Cash Discounts
Cash discounts are granted by virtually every seller of industrial goods. The actual discount
terms are determined by individual trade custom and vary considerably. The purpose of a
cash discount is to secure the prompt payment of an account.
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For example, a 2/10 net 30 cash discount means a discount of 2 percent if payment is
made within 10 days, with the gross amount due in 30 days. This is the equivalent of earning an annual interest rate of approximately 36 percent. If the buying company does not
pay within the 10-day discount period but instead pays 20 days later, the effective cost for
the use of that money for the 20 days is 2 percent (the lost discount). Because there are approximately 18 20-day periods in a year, 2% ⫻ 18 ⫽ 36%, the effective annual interest rate.
Most sellers expect buyers to take the cash discount. The net price is commonly fixed
at a point that will yield a fair profit to the supplier and is the price the supplier expects
most customers to pay. Those who do not pay within the time limit are penalized and are
expected to pay the gross price. However, variations in cash discount amounts frequently
are used merely as another means of varying prices. If a buyer secures a cash discount not
commonly granted in the past, the net result is merely a reduction in the price. A reduction
in the size of the cash discount is, in effect, an increase in the price.
Cash discounts sometimes raise difficult questions about price policy. If the same terms
and practices are granted to all buyers, then the supply department’s major interest in cash
discounts is bringing them to the attention of financial managers. The purchaser ordinarily
cannot be held responsible for a failure to take cash discounts because this depends on the
financial resources of the organization and is, therefore, a matter of financial rather than
supply policy. The purchaser should, however, be very careful to secure such cash discounts as customarily are granted. The buyer is responsible for ensuring prompt inspection
and acceptance and expeditious document handling so discounts may be taken.
The exact date by which payment must be mailed or electronically transferred to take
the discount must be established. Some purchase orders specify that “determination of the
cash discount payment period will be calculated from either the date of delivery of acceptable goods, or the receipt of a properly prepared invoice, whichever date is later.”
Some customers will take the cash discount even when they are paying after the discount date. Part of the buyer’s responsibility is to ensure that his or her organization lives
up to the terms and conditions of the contract. This means working with other functional
areas to ensure that payment is made in a timely manner.
Trade Discounts
Trade discounts are granted by a manufacturer to a particular type of distributor or user.
They aim to protect the distributor by making it more profitable for a purchaser to buy
from the distributor than directly from the manufacturer. Manufacturers use distributors
in territories where the distributors can sell more cheaply than the manufacturer. The distributor is granted a trade discount approximating the cost of doing business to move goods
through the channel.
Trade discounts may be used improperly when protection is granted to distributors not
entitled to it, because the services they provide to manufacturers and customers are not
commensurate with the discount. Generally speaking, buyers dealing in small quantities
who secure a great variety of items from a single source or who depend on frequent and
very prompt deliveries are more likely to obtain their supplies from wholesalers and other
distributors receiving trade discounts. Manufacturers are more likely to sell directly to
large accounts, even though they may reserve the smaller accounts in the same territory for
the wholesalers. Some manufacturers refuse to sell to accounts below a stipulated minimum annual volume.
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Discounts often are available to a buyer who also purchases aftermarket requirements
(replacement parts for units already sold). The supplier may put the buyer who wishes
to buy items that will be sold to the aftermarket into one of several price classifications:
(1) an OEM (original equipment manufacturer) class, (2) a class with its distributors, or
(3) a separate OEM aftermarket class. Aftermarket suppliers often do special packaging,
part numbering, or stocking, which may justify a special price schedule. The buyer needs
to know what price classifications the supplier uses and the qualifications for placing the
buyer in a particular classification.
Multiple Discounts
In some industries and trades, prices are quoted on a multiple discount basis. For example,
10, 10, and 10 means that, for an item listed at $100, the actual price to be paid by the
purchaser is ($100 ⫺ 10%) ⫺ 10%($100 ⫺ 10%) ⫺ 10%[($100 ⫺ 10%) ⫺ 10%($100 ⫺
10%)] ⫽ $100 ⫺ $10 ⫺ $9 ⫺ $8.10 ⫽ $72.90. The 10, 10, and 10 is, therefore, equivalent
to a discount of 27.1 percent. Tables are available listing the most common multiple discount combinations and their equivalent discount.
Quantity Discounts
Quantity discounts apply to particular quantities and vary roughly in proportion to the
amount purchased. Sellers grant such discounts because volume purchases result in savings to the seller, enabling a lower price to the buyer. These savings may be marketing or
distribution expense or production expense.
Marketing or distribution savings occur because it may be no more costly to sell a large
order than a small one; the billing expense is the same; and the increased cost of packing,
crating, and shipping is not proportional. A direct quantity discount not exceeding the difference in cost of handling the small and the large order is justified. Transport savings (e.g.,
truckload [TL] versus less-than-truckload [LTL]) is a classical example of quantity discounts.
Production cost savings occur because setup costs may be the same for a large order as
a small one or material costs may be lower per unit.
For the buyer, quantity discounts are intimately connected with inventory policy. Larger
order sizes may mean lower unit price, but carrying charges on larger inventory are more
costly. Hence, the savings on the size of the order must be compared against the increased
inventory costs.
The Price-Discount Problem
Accepting a price discount for ordering larger quantities leads to higher levels of anticipation
inventory. Marginally, the question is “Should we increase the size of our inventory so that
we obtain the benefits of the lower price?” This can be analyzed as a return on investment
(ROI) decision. The simple EOQ model is not of much assistance here because it cannot
account for the purchase price differential directly. It is possible to use the EOQ model to
eliminate some alternatives, however, and to check the final solution (see Chapter 8). Total
cost calculations are required to find the optimal point.
The following problem is illustrative of the calculation:
R ⫽ 900 units (annual demand)
S ⫽ $50 (order cost)
K ⫽ 0.25 or 25 percent (annual carrying cost)
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Total annual price paid
Carrying cost
Order cost
Total cost
Average inventory
EOQ (units)
271
100
200
400
800
$40,500
562
450
41,512
$2,250
89
$38,700
1,075
225
40,000
$4,300
92*
$37,350
2,075
112
39,537
8,300
93*
$36,000
4,000
56
40,056
16,000
94*
* Not feasible
C ⫽ $45 for 0–199 units per order
$43 for 200–399 units per order
$41.50 for 400–799 units per order
$40 for 800 and more units per order
A simple marginal analysis shows that in moving from 100 per order to 200, the additional average investment is $4,300 ⫺ $2,250 ⫽ $2,050. The saving in price is $40,500 ⫺
$38,700 ⫽ $1,800, and the order cost saving is $450 ⫺ $225 ⫽ $225. For an additional
investment of $2,050, the savings are $2,025, which is almost a 100 percent return and is
well in excess of the 25 percent carrying cost. In going from 400 to 800, the additional
investment is $7,700 for a total price and order savings of $1,406.25. This falls below the
25 percent carrying cost and would not be a desirable result. The total cost numbers show
that the optimal purchase quantity is at the 400 level. The largest single saving occurs at
the first price break at the 200 level.
The EOQs with an asterisk are not feasible because the price range and the volume do
not match. For example, the price for the second EOQ of 92 is $45. Yet for the 200 to 400
range, the actual price is $43. The EOQ may be used, however, in the following way. In
going from right to left on the table (from the lowest unit price to the highest price), proceed until the first valid EOQ is obtained. This is 89 for the 0 to 199 price range. Then the
order quantity at each price discount about this EOQ is checked to see whether total costs
at the higher order quantity are lower or higher than at the EOQ. Doing this for the example
shown gives us a total cost at the valid EOQ level of 89 of:
Total annual price paid
Carrying cost
Order cost
Total cost
$ 40,500
500
500
$ 41,500
Because this total cost at the feasible EOQ of 89 units is above the total cost at the 200
order quantity level and the 400 and 800 order levels as well, the proper order quantity is
400, which gives the lowest total cost of all options.
The discussion so far has assumed that the quantity discount offered is based on orders
of the full amount, forcing the purchaser to carry substantial inventories. The buyer prefers to take delivery in smaller quantities, but still get the discounted price. This might be
negotiated through annual contracts, cumulative discounts, or blanket orders. This type of
analysis also can identify what extra price differential the purchaser might be willing to pay
to avoid carrying substantial stocks.
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Quantity Discounts and Source Selection
The quantity discount question is also of interest because all quantity discounts, and especially those of the cumulative type, tend to restrict the number of suppliers, thereby affecting the choice of source.
The buyer should obtain discounts whenever possible. Ordinarily they come through
the pressure of competition among sellers. Furthermore, an argument may be advanced
that such discounts are a matter of right. The buyer is purchasing goods or merchandise,
not crating or packing materials or transportation. The seller presumably should expect
to earn a profit, not from those wholly auxiliary services, but rather from manufacturing
and selling the merchandise processed. These auxiliary services are necessary, they must
be performed, they must be paid for, and it is natural to expect the buyer to pay for them.
But the buyer should not be expected to pay more than the actual cost of these auxiliary
services.
When quantity discounts are justified because they contribute to reduced production
costs by providing a volume of business large enough to reduce overhead expenses, more
cautious reasoning is necessary. It is true that in some lines of business the larger the
output, the lower the overhead cost per unit of product. It also may be true that without
the volume from the large customers, the average cost of production would be higher.
However, the small volume buyers may place a greater total proportion of the seller’s
business than do the large volume ones. For production costs, therefore, the small volume buyers may contribute even more toward that volume so essential to the per-unit
production cost than does the larger buyer.
Large customers may contend that ordering early in the season or prior to actual production justifies higher discounts because their orders keep the facility in production. While
early season ordering may justify a lower price than later ordering, it should be granted
to every order regardless of its size. This would properly be called a time discount, not a
quantity discount.
Cumulative or Volume Discounts
A cumulative discount varies in proportion to the quantity purchased. It is based on the
quantity purchased over a period of time not on the size of any one order. It is an incentive
for continued patronage and the concentration of orders with a single supplier. Typically,
distributing one’s orders over many sources is uneconomical and costly. The supplier may
pay more attention to the buyer’s requirements if it is getting the larger portion of the purchaser’s business.
The use of cumulative discounts must meet the same cost justification rules under the
Robinson-Patman Act as other quantity discounts. However, as long as the buyer is not
knowingly accepting or inducing discriminatory quantity discounts, then the responsibility
for justification rests solely with the seller.
Cumulative discounts, if provided in the form of a payment by the supplier after the
specified contract date, can provide tangible evidence of purchasing savings, especially if
the discounts were not included in budgets or standard costing systems.
It may be easier for a supplier to provide a discount to a purchaser than a lower price.
This allows the supplier to keep established list prices unchanged and distinguish between
various classes of purchasers.
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273
CONTRACT OPTIONS FOR PRICING
Four contract options for pricing are firm-fixed-price (FFP), cost-plus-fixed-fee (CPFF),
cost-no-fee (CNF), and cost-plus-incentive-fee (CPIF).
Firm-Fixed-Price (FFP) Contract
The price set is not subject to change, under any circumstances. Buyers prefer this type of
contract, but if the delivery date is some months or years away and if there is substantial
chance of price escalation, a supplier may feel that there is far too much risk of loss to agree
to sell under an FFP contract.
Cost-Plus-Fixed-Fee (CPFF) Contract
If it is unreasonable to expect a supplier to sell at a firm fixed price, the CPFF contract can
be used. This occurs if the item is experimental and the specifications are not firm, or if
costs in the future cannot be predicted. The buyer agrees to reimburse the supplier for all
reasonable costs incurred (under a set of definite policies under which “reasonable” is determined) in doing the job or producing the required item, plus a specified dollar amount of
profit. A maximum amount may be specified for the cost. This contract type is far superior
to the old “cost-plus-percentage” type, which encouraged the supplier to run the costs up as
high as possible to increase the base on which the profit is figured. While the supplier bears
little risk under the CPFF, since costs will be reimbursed, the supplier’s profit percentage
declines as the costs increase, giving some incentive to the supplier to control costs.
Cost-No-Fee (CNF) Contract
If the buyer can argue persuasively that there will be enough subsidiary benefits to the supplier from doing a particular job, then the supplier may be willing to do it provided only
the costs are reimbursed. For example, the supplier may be willing to do the research and
produce some new product if only the costs are returned, because doing the job may give
the supplier some new technological or product knowledge, which then may be used to
make large profits in some commercial market.
Cost-Plus-Incentive-Fee (CPIF) Contract
Both buyer and seller agree on a target cost figure, a fixed fee, and a formula under which
any cost over- or underruns are shared. For example, assume the agreed-on target cost is
$100,000, the fixed fee is $10,000, and the incentive-sharing formula is 50/50. If actual
costs are $120,000, the $20,000 cost overrun would be shared equally between buyer and
seller, based on the 50/50 sharing formula, and the seller’s profit would be reduced by
$10,000, or to zero in this example. On the other hand, if total costs are only $90,000, then
the seller’s share of the $10,000 cost underrun would be $5,000. Total profit then would
be $10,000 ⫹ $5,000, or $15,000. This motivates the supplier to be efficient because the
benefits of greater efficiency (or the penalties of inefficiency) accrue in part, based on the
sharing formula, to the supplier.
Provision for Price Changes
Many long-term contracts contain provisions for price changes. The contract normally provides for no price changes for a fixed period of time, after which a price change may become
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possible with a minimum notice period (for example, see the Loren case in Chapter 12).
There are several options for price changes.
Guarantee against Price Decline
For recurring purchases and for raw materials, the contract may be written at the price in
effect at the time the contract is negotiated. Provision is made for a reduction during a subsequent period if there is a downward marketplace price movement. The contract specifies
how a price change is determined, typically by a specific business or trade publication or
Web site. Buyers prefer this provision when it overcomes their reluctance to buy because
of fear that prices are likely to drop still further.
Price Protection Clause
In a long-term contract for raw materials or other key purchased items with one or more
suppliers, the buyer may want to keep open the option of taking advantage of a lower
price offered by a different supplier. This might be done by either buying from the noncontract supplier or forcing the contract supplier(s) to meet the lower price available from
the noncontract suppliers. A price protection clause may be incorporated into the contract
specifying that “If the buyer is offered material of equal quality in similar quantities under
like terms from a responsible supplier, at a lower delivered cost to the buyer than specified in this contract, the seller on being furnished written evidence of this offer shall either
meet the lower delivered price or allow the buyer to purchase from the other supplier at
the lower delivered price and deduct the quantity purchased from the quantity specified in
this contract.”
Escalator Clauses
The actual wording of many escalator clauses provides for either an increase or decrease
in price if costs change. Escalator clauses came into common use during the hyperinflation
years in the 1970s when suppliers believed that the uncertainty of future costs made firm
quotation either impossible or, if covering all probable risks, so high as to make it unattractive, and perhaps unfair, to the buyer.
There are several general and many specific problems with escalator clauses. These
include determining the proportion of the total price subject to adjustment; the particular
measures of prices and wage rates to be used in making the adjustment; the methods to be
followed in applying these averages to the base price; the limitations, if any, on the amount
of adjustment; and the methods for making payment.
When prices are stable, escalation usually is reserved for long-term contracts in which
certain costs may rise and the seller has no appreciable control over this rise. When prices
are unstable, with inflation, shortages, and sellers’ markets, escalation becomes common
on even short-term contracts as sellers attempt to ensure the opportunity to raise prices and
preserve contribution margins. Changes in material and direct labor costs generally are
tied to one of the published price and cost indexes, such as those of the Bureau of Labor
Statistics or one of the trade publications, such as Iron Age or the Chemical Marketing
Reporter. It can be a problem finding a meaningful index to use. Because most escalation
is automatic once the index, the portion of the contract subject to escalation, the frequency
of revision, and the length of contract have been agreed to, the need for care in deciding on
these factors is obvious.
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The following is an illustrative escalator clause:
Labor
Adjustment with respect to labor costs shall be made on the basis of monthly average hourly
earnings for the (Durable Goods Industry, subclass Machinery), as furnished by the Bureau
of Labor Statistics (hereafter called the Labor Index). Adjustments shall be calculated with
respect to each calendar quarter up to the completion date specified in contract. The percentage increase or decrease in the quarterly index (obtained by averaging the Labor Index
for each month of the calendar quarter) shall be obtained by comparison with the Labor
Index for the base month. The base month shall be____ 201____. The labor adjustment for
each calendar quarter as thus determined shall be obtained by applying such percentage of
increase or decrease to the total amount expended by the contractor for direct labor during
such quarter.
Materials
Adjustment with respect to materials shall be made on the basis of the materials index for
Group VI (Metals and Metal Products), as furnished by the Bureau of Labor Statistics (hereafter called the Materials Index). Adjustments shall be determined with respect to each calendar
quarter up to the completion date specified in the contract. The percentage of increase or
decrease in the quarterly index (obtained by averaging the Materials Index for each month of
the calendar quarter) shall be obtained by comparison with the Materials Index for the base
month. The base month shall be____ 201____. The material adjustment for each calendar
quarter shall be obtained by applying to the contract material cost the percentage of increase
or decrease shown by the Materials Index for that quarter.
A buyer who uses escalator clauses must remember that one legal essential to any enforceable purchase contract is that it contains either a definite price or the means of arriving
at one. No contract for future delivery can be enforced if the price of the item is conditioned entirely on the will of one of the parties. The clauses cited earlier would appear to
be adequate. So too are clauses authorizing the seller to change price as costs of production
change, provided that these costs can be reasonably determined from the supplier’s accounting records.
Most-Favored-Customer Clause
Another price protection clause (sometimes referred to as a “most-favored-nation clause”)
specifies that the supplier, over the duration of the contract, will not offer a lower price to
other buyers, or if a lower price is offered to others, it will apply to this contract as well.
Contract Cancellation
Cancellations usually occur during a period of falling prices. At such times, some buyers find loopholes and technicalities in the purchase order or sales agreement to reject
merchandise. One can have sympathy for the buyer with a contract at a price higher than
the market price. There is little justification, however, for the purchaser who follows a cancellation policy under this situation. A contract should be considered a binding obligation.
Canceling a contract because of falling market prices is not justified. Sometimes the buyer
knows when the purchase order is placed that the customer for whose job the materials are
being bought may unexpectedly cancel the order, thus forcing cancellation of purchase
orders for materials planned for the job. This is a common risk when purchasing materials
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for use on a government contract, for appropriation changes often force the government to
cancel its order, which results in the cancellation of a great many purchase orders by firms
that were to have been suppliers to the government under the now-canceled government
contract. Or severe changes in the business cycle may trigger purchase-order cancellations.
If cancellation is a possibility, the basis and terms of cancellation should be agreed on and
included in the terms and conditions. Problems such as how to value and what is an appropriate payment for partially completed work on a now-canceled purchase order are best
settled before the situation arises.
FORWARD BUYING AND COMMODITIES
Forward buying is the commitment of purchases in anticipation of future requirements beyond current lead times. An organization may buy ahead because of anticipated shortages,
strikes, or price increases. As the time between procurement commitment and actual use
of the requirement grows, uncertainties also increase. One common uncertainty is whether
the actual need will be realized. A second concern is with price. How can the purchaser
ascertain that the price currently committed is reasonable compared to the actual price that
would have been paid had the forward buy not been made?
Commodities represent a special class of purchases frequently associated with forward
buying. Almost all organizations purchase commodities in a variety of processed forms.
For example, an electrical equipment manufacturer may buy a substantial amount of wire,
the cost of which is significantly affected by the price of copper. Many organizations buy
commodities for further processing or for resale. For them, the way they buy and the prices
they pay for commodities may be the single most important factor in success. Prices for selected commodities are reported daily in The Wall Street Journal and many other sources,
in hard copy or on the Internet.
Forward Buying versus Speculation
All forward buying involves some risk. In forward buying, purchases are confined to actually known requirements or to carefully estimated requirements for a limited period of
time in advance. The essential controlling factor is need. Even when the organization uses
order points and order quantities, the amount to be bought may be increased or decreased
in accordance both with probable use and with the price trend, rather than automatically
reordering a given amount. Temporarily, no order may be placed at all.
This may be true even when purchases have to be made many months in advance, such
as seasonal products like wheat, or those that must be obtained abroad, such as cocoa or
coffee. The price risk increases as the lead time grows longer, but the basic reasons for
these forward commitments are assurance of supply to meet requirements and price.
Speculation seeks to take advantage of price movements. At times of rising prices, commitments for quantities beyond anticipated needs would be called speculation. At times of
falling prices, speculation would consist of withholding purchases or reducing quantities
purchased below the safety limits, thereby risking stockouts as well as rush orders at high
prices, if the anticipated price decline did not materialize.
At best, any speculation, in the accepted meaning of the term, is a risky business,
but speculation with other people’s money has been cataloged as a crime. It is supply’s
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responsibility to provide for the known needs to the best advantage possible at the time
and to keep the investment in unused materials at the lowest point consistent with safety of
operation. Purchasers can buy forward, but should not speculate or gamble.
Organizing for Forward Buying
The organization’s size, financial strength, and the percentage of total cost represented
by volatile commodities influences how the company organizes to determine and execute
policy on long-term commodity commitments. In some instances, the CEO exercises complete control, based almost wholly on personal judgment. In other cases, although the CEO
assumes direct responsibility, a committee provides assistance.
Some organizations designate a person, other than the supply manager, whose sole responsibility is price-sensitive materials and who reports directly to top management. Often,
the supply manager controls the commodity inventory. Or an outside agency specializing
in speculative commodities executes policy. The soundest practice for most organizations
appears to be to place responsibility for policy in the hands of a committee consisting of the
top executive or general manager, an economist, a risk manager, and the supply manager.
Actual execution of the broad policy should rest with the supply department.
Control of Forward Buying
Safeguards should be set up to ensure that commodity commitments will be kept within
proper bounds. For example, a leather company established the following safeguards:
(1) Forward buying must be confined to those hides that are used in the production either
of several different leathers or of the leathers for which there is a stable demand. (2) Daily
conferences are held among the president, treasurer, sales manager, and hide buyer.
(3) Orders for future delivery of leather are varied in some measure in accordance with
the company’s need for protection on hide holdings. Because the leather buyer is willing
to place orders for future delivery of leather when prices are satisfactory, this company
follows the practice of using unfilled orders as a partial hedge of its hide holdings. In general, the policy is to have approximately 50 percent of the total hides the company owns
covered by sales contracts for future production of leather. (4) A further check is provided
by an operating budget that controls the physical volume of hides rather than the financial
expenditures, and that is brought up for reconsideration whenever it is felt necessary.
(5) There is a final check that consists of the use of adequate and reliable information,
statistical and otherwise, as a basis for judging price and market trends.
This particular company does not follow the practice of hedging on an organized commodity exchange as a means of avoiding undue risk, though many companies do. Nor does
this company use any of the special accounting procedures, such as last-in, first-out or
reproduction-cost-of-sales, in connection with its forward purchases.
These various control devices, regarded as a unit rather than as unrelated checks, should
prove effective. They are not foolproof, nor do they ensure absolutely against the dangers
inherent in buying well in advance. However, flexibility in the administration of any policy
is essential, and, for this one company at least, their procedure combines reasonable protection with flexibility.
In organizations requiring large quantities of commodities whose prices fluctuate
widely, the risks involved in buying ahead, under some circumstances, may be substantially minimized through the use of the commodity exchanges.
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The Commodity Exchanges
The prime function of an organized commodity exchange is to furnish an established marketplace where the forces of supply and demand may operate freely as buyers and sellers
carry on their trading. An exchange that has facilities for both cash and futures trading
also can be used for hedging operations. The rules governing the operation of an exchange
are concerned primarily with procedures for the orderly handling of the transactions negotiated on the exchange, providing, among other things, terms and time of payment, time of
delivery, grades of products traded, and methods of settling disputes.
In general, the purposes of a commodity exchange will be served best if the following
conditions are present:
1. The products traded are capable of reasonably accurate grading.
2. There are a large enough number of sellers and buyers and a large enough volume of
business so that no one buyer or seller can significantly influence the market.
In order for a commodity exchange to be useful for hedging operations, the following
conditions also should be present:
1. Trading in “futures”—the buying or selling of the commodity for delivery at a specified
future date.
2. A fairly close correlation between “basis” and other grades.
3. A reasonable but not necessarily consistent correlation between “spot” and “future” prices.
All of these conditions usually are present on the major grain and cotton exchanges, and in
varying degrees on the minor exchanges, such as those on which hides, silk, metals, rubber,
coffee, and sugar are traded. Financial futures also permit a firm to hedge against interest rate
fluctuations, which are one of the strongest factors affecting exchange rate fluctuations.
One of the most easily accessed sources of information about futures and options prices
is the commodities section carried Monday through Friday in The Wall Street Journal. It
reports prices from the major exchanges, from North/Latin America (e.g., Chicago Board
of Trade [CBOT], ICE Canada [formerly the Winnipeg Commodity Exchange], Mexico
Bolsa, and Brazil Bovespa); Europe/Africa (e.g., NYSE Euronext, NYSE Liffe [formerly
the London International Financial Futures Exchange], South Africa Futures Exchange
[SAFEX]); and Asia/Pacific (e.g., Tokyo Commodity Exchange [TOCOM], Hong Kong
Exchanges and Clearing [HKFE], and the Australian Securities Exchange [ASX]. [ASX]).
Each of the major commodity trading exchanges has a Web site that provides real-time
information for quotes, charts and historical data, and news.
The commodities traded on the exchanges vary; if the volume is not large enough, a
given commodity will drop off the exchange either temporarily or permanently. However,
the following agricultural items, metals, petroleum products, and currencies normally are
among those listed on any given day: corn, oats, soybeans, soybean oil, wheat, canola,
cattle, hogs, pork bellies, cocoa, coffee, sugar, cotton, orange juice, copper, gold, platinum,
silver, crude oil, heating oil, gasoline, natural gas, Japanese yen, Euro, Canadian dollar,
British pound, Swiss franc, Australian dollar, U.S. dollar, and Mexican peso.
In most cases, the prices quoted on the exchanges and the record of transactions completed furnish some clue, at least, to the current market price and to the extent of the trading
in those commodities. They offer an opportunity, some to a greater extent than others, of
protecting the buyer against basic price risks through hedging.
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279
Limitations of the Exchanges
There are limitations to these exchanges as a source of physical supply for the buyer. In
spite of a reasonable attempt to define the market grades, the grading often is not sufficiently accurate for manufacturing purposes. The cotton requirements of a textile manufacturer are likely to be so exacting that even the comparatively narrow limits of any specific
exchange grade are too broad. Moreover, the rules of the exchange are such that the actual
deliveries of cotton do not have to be of a specific grade but may be of any grade above
or below basic cotton, provided, of course, that the essential financial adjustment is made.
This also holds true for wheat. Millers who sell patented blended flours must have specific
types and grades of wheat, which normally are purchased by use of a sample.
There are other reasons why these exchanges are not satisfactory for the buyer endeavoring to meet actual physical commodity requirements. On some of the exchanges, no spot
market exists. On others there is a lack of confidence in the validity of the prices quoted.
Crude rubber, for example, is purchased primarily by tire manufacturers, a small group of
very large buyers. On the hide exchange, on the other hand, a majority of hides sold are
by-products of the packing industry, offered by a limited number of sellers. An increase or
a decrease in the price of hides, however, does not have the same effect on supply that such
changes might have on some other commodities.
It is not asserted that these sellers use their position to manipulate the market artificially
any more than it is asserted that the buyers of rubber manipulate the market to their advantage. In these two cases, however, the prices quoted might not properly reflect supply and
demand conditions.
Hedging
The commodity exchanges provide a manufacturer an opportunity to offset transactions,
and thus to protect, to some extent, against price and exchange risks. This commonly is
done by hedging.
A hedging contract involves a simultaneous purchase and sale in two different markets,
which are assumed to operate so that a loss in one will be offset by an equal gain in the
other. Normally this is done by a purchase and sale of the same amount of the same commodity simultaneously in the spot and futures markets.
Hedging can occur only when trading in futures is possible. A simple example follows:
In the Cash Market
On September 1:
Processor buys
5,000 bushels of wheat shipped from
country elevator at $4.00 per bushel
(delivered Chicago)
On October 20:
Processor sells
Flour based on wheat equivalent of 5,000
bushels priced at $3.85 per bushel
(delivered at Chicago)
Loss of 15¢ per bushel
joh77899_ch10_253-287.indd 279
In the Futures Market
Processor sells
5,000 bushels of December
wheat futures at $4.10 per
bushel
Processor buys
5,000 bushels of December
wheat futures at $3.95 per bushel
Gain of 15¢ per bushel
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280 Purchasing and Supply Management
In the example, it is assumed that the cash or spot price and the futures price maintained
a direct correlation, but this is not always the case. Thus, there may be some gain or loss
from a hedging operation when the spread between the spot price and the futures price does
not remain constant. Hedging can be looked on as a form of insurance, and, like insurance,
it is seldom possible to obtain 100 percent protection against all loss, except at prohibitive
costs. As the time between the spot and future declines, the premium or discount on the
future declines toward zero (which it reaches when spot ⫽ future). On seasonal commodities, this decline in price differential usually begins six to eight months in advance. Under
certain circumstances, this phenomenon can make “risk-free” speculation possible. For
example, when the speculator has access to a large amount of money, at least three times
the value of the contract, and when a six- to eight-month future premium exceeds the sum
of contract carrying cost and inventory and commission cost, the “speculator” can buy spot
and short the future with a precalculated profit. Volume on the exchange should be heavy
for this kind of operation.
While there are other variations of the techniques used in hedging, the one simple example is sufficient for the present discussion of forward and speculative buying.
Successful hedging on an exchange requires skill, experience, and capital resources. This
may limit small organizations. It also explains why organizations using large amounts of a
certain commodity often own memberships on the relevant exchange. A representative may
then be constantly watching for advantageous opportunities for placing, withdrawing, or
switching hedges between months and can translate this judgment into immediate action. To
be successful, the actual procedure of hedging calls for the close observation of accumulating stocks of the commodity, the consequent widening or narrowing of the spreads between
prices quoted on futures contracts, and the resulting opportunities for advance opening and
closing of trades. These factors are constantly shifting on the exchanges. The skill of the
hedger is reflected in the ability to recognize and grasp these momentary opportunities.
Hedging may not always be helpful or advantageous to the purchaser. One obstacle to a
wider use of the exchanges is the lack of understanding by potential users about when and
how to use them. Another limitation is the vacuum effect when one of the relatively few
large commodity brokers goes bankrupt, pulling some clients along.
Moreover, most brokers have not shown extensive interest in the industrial market.
Most brokers probably will admit that they can barely afford to service a straight hedger
because they may have to send out six monthly position statements and four or more margin calls for a single round turn commission, while their faithful “traders” will often maintain a substantial cash account and net them several round turn commissions per month
with a minimum of bookkeeping.
Furthermore, many managers still view futures trading with suspicion and tend to blame
past mistakes on the system rather than managerial errors of judgment. The large variations
in commodity prices in recent years may well have sensitized a number of managers to the
opportunities in futures trading, where before there seemed little need to be involved.
Sources of Information Regarding Price Trends
There are five general sources of price trend information. All have limitations on their
value and dependability. Most of the organizations listed below have online services that
permit access to data on a real-time basis.
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Chapter 10 Price
281
One source of information consists of the services of specialized forecasting
agencies, such as Moody’s Investors Service. A second source is the commodity
exchanges, which typically provide historical information about prices and volumes.
Most exchanges also provide access to reports by government agencies and some
analysts.
The third source includes a wide variety of governmental and other published data,
such as the Federal Reserve Bulletin, the Survey of Current Business, BusinessWeek,
Bloomberg.com, Barron’s, and The Wall Street Journal. Trade magazines also are helpful
in particular industries and are typified by such publications as Iron Age and Chemical
Market Reporter. Probably the most-watched indicator of industrial purchase prices is
the producer price index (PPI) compiled and released monthly by the Bureau of Labor
Statistics. It previously was called the wholesale price index (WPI). The PPI is a family
of indexes that measure the average change over time in selling prices received by U.S.
domestic producers of goods and services. It measures price changes from the perspective
of the seller and is available in three types of classification: industry-based, commoditybased, and stage-of-processing-based. A companion measure, also produced monthly by
the Bureau of Labor Statistics, is the consumer price index (CPI). The CPI is based on the
prices from the perspective of the end purchaser.
The fourth source comprises the highly unscientific—but nevertheless valuable, if properly weighted—information derived from sales representatives, other buyers, and others
with whom the buyer comes in daily contact.
The fifth source of information is the purchasing manager indexes for the United
States and Canada. Each month, ISM releases the Manufacturing Report on Business
(ROB) and the Nonmanufacturing ROB. In Canada, the Ivey Purchasing Managers Index
is also released monthly. Both of these reports provide a useful service by presenting a
composite reading by supply managers across the United States or Canada in a number of
areas, such as prices, inventory levels, lead times, new orders, production, and employment. JPMorgan and Markit in association with ISM and the International Federation of
Purchasing and Supply Management (IFPSM) generate a monthly global manufacturing
and services PMI.
Conclusion
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Price determination can be a tricky issue. The method of price determination should be
influenced by what is being bought and the characteristics of the supply market at that
particular point in time relative to the strategic goals of the organization. Discounts offer
an interesting opportunity for buyers and sellers to achieve their price objectives. Knowing
how to set prices, establishing appropriate strategies for price adjustments, and managing
supply price risk are important skills for supply managers. Buyers who rely on competitive
bidding and one-year contracts for every purchase may miss opportunities for achieving
lower total costs.
Price is one critical element in cost management, the focus of the following chapter. Cost analysis and total cost or life-cycle cost management take price into a bigger
picture of what supply managers must think about. Negotiation is one of the most important skills for supply managers and will also be discussed in the Cost Management
chapter.
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282 Purchasing and Supply Management
Questions
for
Review
and
Discussion
1. What is the significance of the Sherman Antitrust and the Robinson-Patman acts to the
industrial buyer?
2. What advantages does the competitive bid process have as a method of price determination?
3. How is supplier cost related to supplier price?
4. What are the various ways by which prices are determined?
5. What methods can the buyer use to establish price for (a) sensitive commodities,
(b) special items, (c) standard production items, and (d) items of small value?
6. Distinguish between direct and indirect costs. How can the buyer analyze these costs?
7. What can the buyer do if he or she suspects collusion on the part of suppliers?
8. What are cash discounts, quantity discounts, trade discounts, and cumulative discounts? Should the buyer attempt to use these discounts? How?
9. Why might a buyer wish to hedge a commodity purchase? How would the buyer
do that?
10. Does hedging remove all risk?
11. What is the difference between forward buying and speculation?
References
Dubois, A., and A. C. Pedersen. “Why Relationships Do Not Fit into Purchasing Portfolio
Models—A Comparison between the Portfolio and Industrial Network Approaches.”
European Journal of Purchasing & Supply Management 8, no. 1 (2002), pp. 35–42.
Gelderman, C. J., and A. J. van Weele. “Strategic Direction through Purchasing Portfolio
Management: A Case Study.” Journal of Supply Chain Management 28, no. 2 (2002),
pp. 30–38.
Handfield, R. B., and S. L. Straight. “What Sourcing Channel Is Right for You?” Supply
Chain Management Review 7, no. 4 (2003), pp. 62–70.
Mabert, V. A., and T. Schoenherr. “An Online RFQ System: A Case Study.” Practix 4.
Tempe, AZ: CAPS Research, March 2001, pp. 1–6.
Schlosser, M. A., and G. A. Zsidisin. “Hedging Fuel Surcharge Price Fluctuations.”
Practix 7. Tempe, AZ: CAPS Research, May 2004, pp. 1–5.
Zsidisin, G. A., and L. M. Ellram. “An Agency Theory Investigation of Supply Risk
Management.” Journal of Supply Chain Management 39, no. 3 (2003), pp. 15–29.
Case 10–1
Cottrill Inc.
On November the 12th, Judy Stevens, purchasing supervisor at the Cottrill Inc. plant in Columbus, Ohio, was
reviewing a proposal from Saxton Wireless. Judy was
dissatisfied with Cottrill’s paging service from its current
joh77899_ch10_253-287.indd 282
supplier and had been approached by Saxton about switching service providers. She knew that the sales representative at Saxton was expecting a reply later that day and
needed to finalize her decision.
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Chapter 10 Price
COTTRILL INC.
Cottrill was established in the mid-1800s and was the one of
the largest corn refining operations in North America. The
company operated six wet-milling plants, four in the United
States and two in Canada. Cottrill was an industry leader
and maintained this position by continuously developing
new products, technologies, and manufacturing processes.
The Columbus plant had been operating for over
20 years and employed more than 100 people. It produced
high-fructose corn syrup, starch, and glucose, which were
used as supply inputs for a variety of industries including
baked goods, beverages, confections, corrugating paper,
and processed foods. Cottrill competed primarily in the
business-to-business segment and recognized that customers demanded both reliability and consistency.
THE PURCHASING DEPARTMENT
Cottrill’s purchasing department had to ensure that the plant
ran efficiently and was responsible for replenishing a variety of supplies at the plant, ranging from chemicals to communications equipment. A current initiative for Cottrill, and
particularly for the purchasing department, was reducing
the level of working capital. This had been a focus in the
purchasing department for over two years, and the departmental target was an annual decrease of $300,000.
Judy Stevens was the purchasing supervisor at the
Columbus plant and had one employee reporting to her.
In general, the purchasing department had a large degree
of autonomy because most decisions did not have to be
cleared by Judy’s boss, the plant controller.
THE PAGING SYSTEM
The majority of Cottrill’s products were manufactured
through a continuous flow process. Therefore, downtime at the Columbus plant was extremely costly and was
estimated at $200,000 per hour. In an attempt to minimize
plant downtime, management implemented an automated
software program and an electronic pager system 12 years
ago. The software program, called ProductionMessaging,
monitored Cottrill’s equipment. If an unusual condition,
such as heat failure, was detected, this system automatically sent out a warning message to a pager. Pagers were
grouped by process so that, in the event of a malfunction,
only the appropriate technicians and supervisors were notified. The plant had a total of 20 pagers, and this number
included a variety of different models.
Usually one warning was experienced per week. Depending on the message sent by the system, pages could
joh77899_ch10_253-287.indd 283
283
report a machine malfunction or simply inform staff about
potentially anomalous machine operating statistics.
THE CURRENT SYSTEM
Cottrill initially approached Tallant, a large international
wireless company, 12 years ago because they offered the
only paging service that could be used in conjunction
with the ProductionMessaging software system. The current contract with Tallant was open-ended and required
30 days’ notice if Cottrill wished to terminate the contract.
Tallant did not provide Cottrill with a designated service
representative. Instead, if a problem occurred, someone
would call a 1-800 number and then wait on hold until
his or her call was taken to speak with a customer service representative. This process could become an issue if
Cottrill was placed on hold during a plant emergency for
an extended period of time.
Several recent events had caused Judy to become dissatisfied with the current arrangement with Tallant. In
June, Judy contacted Tallant with a routine request to replace a broken pager. Judy was dissatisfied with Tallant’s
service, feeling that she spent too much time on the phone
arranging the order, and it took Tallant over a month to
send out the replacement pager.
Judy contacted Tallant again in September to replace
another pager. She was informed that Tallant no longer
carried this model and that the option of renting the pager
hardware would be discontinued in the near future. Judy
ordered a comparable product, valued at approximately
$150, but felt a little unsettled by the new information.
Cottrill’s budget was tight and she preferred renting this
equipment instead of purchasing for cash flow reasons.
Although annoyed with the disappointing level of service
from Tallant, Judy was consumed with more pressing issues at Cottrill and brushed off both incidents.
THE SAXTON PROPOSAL
In late October, a Saxton sales representative, Natalie
Hopkins, contacted Judy to present a proposal outlining
the benefits to Cottrill of switching to Saxton’s services.
Saxton offered a simpler fee structure and also a lower
overall cost than Tallant (see Exhibit 1). Additionally,
by switching to Saxton, Judy would be able to directly
access Natalie by e-mail or by phone if any service issues
arose.
Although Saxton was a large wireless services company, it did not have the established reputation in the area
of in-plant wireless messaging systems, nor did it have
the local service history that Tallant did. Judy wondered
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284 Purchasing and Supply Management
EXHIBIT 1 Per-Unit Comparison of Service Terms for Tallant and Saxton
Monthly fee for airtime (per pager)
Monthly fee for phone number (per pager)
Monthly fee for equipment rental (per pager)
Yearly maintenance fee (per pager)
Service provided (no additional cost)
about Saxton’s current customers and was unclear whether Saxton had the necessary experience to handle the technological requirements of Cotrill’s account. Tallant also
required notice upon termination of the agreement, and
Judy recognized that the paging service time frames could
overlap due to this constraint, effectively forcing Cottrill
to pay for paging services from both companies during the
transition. Additionally, if Cottrill did switch suppliers, all
of the existing pager numbers would need to be changed,
and plant staff would need to be informed of the switch.
Since the initial meeting had gone well, both Judy and
Natalie had agreed to move forward with the process and
schedule a trial of Saxton’s hardware. This test was necessary to confirm that Saxton’s pagers would be compatible
with the relevant applications in the ProductionMessaging
software. After Judy spoke with Cottrill’s systems group,
a trial was scheduled for the first week in November.
Judy was not able to be present for the trial, but her
contact in the systems group advised her of the events. Unfortunately, the pagers did not immediately function with
the ProductionMessaging software. However, after several
attempts to solve the functionality issue, Cottrill’s systems
group resolved the snags in the hardware and reworked
the connection after completing some reprogramming. It
appeared that the problem was under control, but Judy
was worried about how easily the Saxton system could
be implemented. Also, she was unsure about how the systems group perceived the functionality problems and if
this would be an issue going forward.
Tallant
Saxton
$16.95
$1.95
$11.90
$60.00
1-800 # help line
$13.95
None
None
None
Direct sales representative
DECISION CRITERIA
Judy often used a structured set of criteria to approach purchasing decisions at Cottrill. Although she had the final
decision-making authority with this issue, she recognized
that the systems group would have to support this switch.
The systems group was primarily concerned with functionality, and providing that the Saxton product could perform
to the similar level of functionality of Tallant, they would
not have any objections to switching suppliers.
Judy wondered which criteria were most important to
the decision of supplier selection and how these issues
should be ranked. Judy knew that before a recommendation could be made, she would have to apply her evaluation framework and proposed criteria to the alternatives.
It was Monday morning, and Judy had taken some time
to think about the issues of the Saxton hardware testing that
had taken place the previous Friday. She had expected the
trial to be executed without incident and wondered if the
decision to switch suppliers was as simple as she had
initially thought. Judy wanted to be certain that she had
considered all of the implications involved with switching suppliers before making a decision. She knew that the
change to Saxton was an option but recognized that Cottrill
could also remain with Tallant and was now wondering if
there were any other alternatives. However, Judy understood that it had been nearly a week since the Saxton sales
representative had presented her proposal, and she was expecting Judy’s response by the end of the day.
Case 10–2
Coral Drugs
Shirley Black glanced at her watch. It was 1 p.m. on
January the 25th, and only two hours remained before
her meeting about Coral Dandruff Shampoo with the
vice president of purchasing. As merchandise group
joh77899_ch10_253-287.indd 284
coordinator at Coral’s head office in Columbus, Ohio,
Shirley was trying to decide whether to recommend
switching from a large shampoo manufacturer to a small
local supplier.
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Chapter 10 Price
CORAL DRUGS
Coral Drugs was founded in 1962. Since that time, the company had steadily expanded its chain of retail drug stores
throughout the state. Currently, Coral operated 114 stores
and planned to add an additional 8 to 10 stores over the
next five years. Coral’s retail outlets sold both prescribed
and over-the-counter pharmaceutical products as well as
other drugstore items. This private company’s strategy was
focused on the further expansion of its successful retail operations. Coral had a strong financial position and intended
to pursue any opportunity that had potential to increase its
bottom line and was related to its retail operations.
CORAL PRIVATE-LABEL PRODUCTS
One such opportunity was the development of Coral
private-label products. Since 1980, the company had aggressively developed a line of products carrying the Coral
name. Currently, Coral stocked over 200 different privatelabel products. Coral was proud of its ability to bring a
product to its shelves that was comparable in quality to
the national brands, but offered at least a 25 percent price
savings to the consumer. The company was able to sell at a
better price than the national brands because it was buying
directly from the manufacturer and its advertising expenditures were significantly lower. Examples of successful
products included Coral Acetaminophen Tablets and Coral
Vitamin Supplements.
Coral private-label products were attractive to the
company for several reasons. First, the margin on these
products averaged 40 percent as compared with 25 percent on national brands. Also, the product line was virtually hassle-free. Apart from the initial supplier approval,
the sourcing agreement left the manufacturer responsible
for all aspects of product development and investment.
Consequently, Coral intended to pursue any growth opportunities this private labeling offered in the future.
SOURCE SELECTION FOR PRIVATELABEL PRODUCTS
Coral private-label products were purchased from 26 different suppliers. Several sourcing agreements were in
contract form, while others were simply an understanding between Coral and the manufacturer. The process for
developing a sourcing agreement began with an internally
generated idea for a potential private-label product. Once
the product idea was approved, Coral announced that it
was accepting bids from manufacturing operations that
wanted to produce the product. Coral carefully analyzed
joh77899_ch10_253-287.indd 285
285
the potential suppliers to ensure that they were able to provide a consistent product that was comparable in quality
to the leading national brands and at a price that would
provide satisfactory margins. When the bid was accepted,
Coral and the manufacturing company worked together to
develop the final product.
Sourcing agreements left the manufacturer responsible for almost all aspects of product development. Based
on specifications provided by Coral, these manufacturers generated the artwork for the product, designed the
packaging, invested in any necessary equipment, and
performed quality assurance. Once the product received
final approval from Coral, the company simply placed an
order for the product when stock was required. The order
was then delivered FOB to Coral’s central warehouse and
shipped from there to the retail stores. Consequently, this
high level of supplier autonomy made annual reevaluation
of the sourcing arrangements necessary.
SWITCHING THE SOURCING
AGREEMENT FOR CORAL
DANDRUFF SHAMPOO
In December, Shirley had reviewed the performance of
the company that produced Coral Dandruff Shampoo—
Twinney Inc. After several requests from Coral to
improve delivery terms, Twinney had indicated that it
would not alter the terms originally agreed upon. Many
of Coral’s concerns were directly related to the location of Twinney’s manufacturing plant 600 miles to the
east. Consequently, in early January, Coral announced
that it was accepting bids on the future production
of the product. A product specification document was
sent to manufacturers that were known to have the capability to produce similar products. Twinney was notified
prior to the announcement and was asked to submit a bid
along with the others.
TWINNEY INCORPORATED
Under the current sourcing agreement, Coral had to order
full skids when purchasing its private-label dandruff shampoo from Twinney. Each skid held 4,000 units. Although
the shampoo was considered an excellent product, volumes for the regular, fragranced, and trial-sized products
averaged only about 20,000 units each annually. Shirley
knew that the inventory carrying cost at Coral was around
2 percent a month, and felt that the company had too much
money tied up in such a low-volume product. Furthermore,
the three- to four-week lead time required when placing an
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286
Purchasing and Supply Management
EXHIBIT 1 Coral Drugs Price and Size Comparison for Coral Dandruff Shampoo
Regular
Fragrance
Trial
Size
Twinney
Size
Gorman & Irizawa
6 oz.
6 oz.
2 oz.
0.72
0.85
0.47
7 oz.
7 oz.
3 oz.
0.70
0.75
0.35
order had been causing problems. On several occasions,
the Coral central warehouse had been stocked out of the
products while waiting for a skid to arrive.
Shirley could not understand why a large company
like Twinney would be so unwilling to accommodate
Coral’s requests for improved shipping terms. Although
there had never been any problems with the consistency
or quality of the shampoo Coral received, Shirley Black
felt that perhaps more beneficial terms could be offered
by a manufacturer located closer to Coral’s warehouse. It
seemed like a perfect opportunity because Twinney’s injection mold for the product had just broken down and the
artwork was due for revision soon. The Twinney sourcing
agreement was not in contract form and, therefore, Shirley
Black believed Coral was not legally obligated to continue
purchasing from Twinney.
GORMAN AND IRIZAWA LTD
Out of the many bids received, the most attractive terms
were offered by a young local company, Gorman and
Irizawa Ltd. (G & I). The bidder agreed to similar responsibilities as those in the existing Twinney agreement, as
well as the same payment terms of 2 percent/10, net 30,
FOB Coral’s warehouse. G & I also offered several additional advantages.
The first benefit was the cost of the product. As illustrated in Exhibit 1, G & I undercut the price Twinney was
offering on all three products. This cost differential was
made even more attractive by the fact that the prices quoted
were for 7-ounce bottles of regular and fragranced product
and 3-ounce trial-sized bottles. The leading national brand
was offered in similar sizes. The existing agreement with
Twinney called for the production of smaller 6-ounce and
2-ounce bottles. Coral’s retail selling price was $1.49 for
the regular and fragranced shampoo and $0.89 for a trialsize bottle. Shirley believed this was an excellent opportunity to pass on more value to the consumer.
The second advantage was G & I’s shipping flexibility. Under the terms of the proposed agreement, the company offered next-day delivery service with no minimum
order quantity. G & I was able to offer such favorable
terms because its manufacturing facility was located near
Coral’s central warehouse.
Shirley believed this was an opportunity to support a
small local company. If Coral agreed to source its dandruff
shampoo from G & I, the account would be one of G & I’s
largest. In a recent tour of the G & I plant, Shirley was impressed by the cleanliness of its manufacturing facilities;
however, she could not help comparing the relatively smallscale operation to Twinney’s large shampoo factory.
SHIRLEY’S RECOMMENDATION
Shirley had discussed the dandruff shampoo sourcing issue with the vice president of purchasing in December
and knew he was expecting a recommendation from her
at the January 25th meeting at 3 p.m. She was well aware
that Coral Drugs had a reputation for long-term relationships with its private-label product suppliers. She was,
therefore, still unsure about which supplier to recommend
for Coral Dandruff Shampoo.
Case 10–3
Price Forecasting Exercise*
You and ____ other members of the class have been asked
to forecast the price of a commodity on ____. So that your
organization may take the most advantageous procure-
ment action possible, your organization needs $5 million
worth of this commodity for delivery between ____ and
____. The amount—$5 million worth—is based on the
* Your instructor will supply the missing information, dates, and so forth.
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Chapter 10 Price
spot price of this commodity on ____. Your report must
address the following four questions:
Question 1. What is the current ____ spot price of
this commodity, based on what quotation? What is the
specification of the commodity, and what is the minimum amount of purchase required for the quoted
price to hold? How much in weight or volume does
$5 million represent?
Question 2. What is the current futures for ____?
Question 3. What spot price do you forecast for this
commodity on ____? Why?
Question 4. In view of your forecast, what recommendations would you make to the executive committee of your organization with regard to the purchase
of this commodity? Would you advise buying now
and taking delivery now, or later? Would you hedge?
Would you delay purchase? Anything else? What
savings do you forecast from your recommendation?
287
on a recognized commodity exchange. Prices must
be reported daily in an accessible news source.
2. Approval for a selected commodity must come from
the instructor. No two teams may select the same
commodity. Commodity selection is on a first-come,
first-served basis.
3. Foreign exchange rates may be an important consideration in your decision.
4. This report has four parts:
a. A written report (in at least two copies) to be
handed in on ____ before 4:30 p.m.
b. A five-minute class report to be presented orally
during class on ____.
c. A written evaluation report (in at least two copies)
to be handed in before 4:30 p.m., ____, including
the ____ actual spot price. The evaluation should
compare a savings (loss) estimate in view of the
recommended action for the weight calculated in
the report.
QUALIFICATIONS
1. The commodity selected may not be a pegged price
in the market in which you are purchasing. It must
be a freely fluctuating price, and it must be traded
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Chapter Eleven
Cost Management
Chapter Outline
Strategic Cost Management
Sources of Competitive Advantage
Frameworks for Cost Management
Cost Management Tools and Techniques
Total Cost of Ownership
Target Pricing
The Learning Curve or Manufacturing
Progress Function
Value Engineering and Value Analysis
Activity-Based Costing
Conclusion
Questions for Review and Discussion
References
Cases
11–1 Deere Cost Management
11–2 McMichael Inc.
11–3 City of Granston
Negotiation
Negotiation Strategy and Practice
Framework for Planning and Preparing
for Negotiation
288
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Key Questions for the Supply Decision Maker
Should we
• Use target pricing?
• Negotiate with our suppliers or accept their existing terms and conditions?
• Estimate total cost of ownership for all our purchases?
How can we
• Understand what it costs our suppliers to manufacture their products or deliver
their services?
• Make a cost analysis on all our large-dollar purchase items?
• Achieve our objectives in a negotiation with an important supplier?
The profit leverage effect of supply (discussed in Chapter 1) lays the foundation for the
role of supply in helping the firm meet strategic goals of continuous improvement, customer service, quality, and increased competitiveness. Leveraging the potential of supply
requires fully exploiting all opportunities to reduce, contain, or avoid costs, resulting in the
lowest total cost of ownership and, hopefully, leading the organization to becoming the
low-cost producer of high-quality goods and services. Cost analysis and cost management
are important whether the source of competitive advantage for a specific product or service
is product leadership (higher perceived product differentiation and lower customer price
sensitivity) or cost leadership (lower perceived product differentiation and higher customer
price sensitivity).
Supply management can contribute to attainment of low-cost-producer status by its
management of internal and external costs. Methods of streamlining the acquisition process and reducing internal costs associated with acquisition were discussed in Chapters 3
and 4. This chapter focuses on managing external costs.
As the status of the supply function in well-managed companies has increased in importance, a more professional attitude has developed in the people responsible for the operation of the function. As the professional competence of the personnel has increased, greater
use has been made of the more sophisticated tools available to the business decisionmaking executive. Negotiation and cost management techniques are prime examples of
this developing professionalism.
In the long run, companies need suppliers that provide the lowest total costs, not necessarily the lowest prices. Consequently, a focus on costs, as opposed to prices, allows
purchasers to make informed decisions and identify opportunities to reduce waste in the
supply chain. However, understanding “what the numbers tell us” is only part of the battle.
Effective buyers also need to understand how and when to use information effectively
in a negotiation setting with important suppliers. This chapter addresses supply’s role in
strategic cost management, describes cost management techniques, and explains basic negotiation concepts. Cost management and negotiation represent a powerful combination
for supply professionals.
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Two key decisions are addressed in this chapter: (1) How can cost management and
negotiation tools help identify opportunities and assure value? (2) How can we determine
the supplier’s costs? deliverer’s cost? our own use costs? and disposal costs?
STRATEGIC COST MANAGEMENT
Strategic cost management is an externally focused process of analyzing costs in terms
of the overall value chain. Cost analysis can be used to measure and improve cost performance by focusing attention on specific cost elements. Cost management systems can be
designed that depend on strategic partnering to achieve competitive advantage. Cost management is a major opportunity area for strong supply leadership and management. Cost
management is a continuous improvement process. The focus is essentially on applying
tools and techniques to sustain cost savings year over year. Supply leaders and managers
must develop a cost culture rather than a price culture with multiple internal stakeholders
and externally with suppliers. Cost management should be part of the standard operating
procedure in every supply management organization.
The actual cost management process in any organization depends on context. What is
the strategic positioning of the organization and how sophisticated is the supply organization in terms of price and cost analysis? If little attention has been paid to spend, then the
opportunities may come from spend aggregation and price-volume leverage, supply base
rationalization, and better terms and condition. As supply develops expertise in cost management, attention turns to avoiding, eliminating, or reducing costs through design and
redesign of products/services, and process improvements internally, within the supplier’s
processes and in joint processes.
Sources of Competitive Advantage
Sources of sustainable competitive advantage are: (1) product differentiation (wherein
customers have low price sensitivity), (2) low cost (wherein customers have high price
sensitivity), and (3) a combination of product differentiation and cost leadership. While
an organization may be positioned strategically in one category, it may have products or
services in both. For example, a technical support center may offer customized support
365/24/7 for a relatively high price and also offer basic online diagnostics and reporting as
part of a standard package. Or a fast-food restaurant chain may compete fiercely on price
with value menus while also offering relatively highly priced specialty hamburgers.
Frameworks for Cost Management
Supply professionals must understand their own organization’s strategic positioning (overall and by product or service) and that of their suppliers. Cost analysis and cost management approaches can then be adapted and applied appropriately. Various tools already
discussed in this text provide a framework for cost management. These include ABC
(Pareto) analysis and portfolio analysis.
ABC or Pareto Analysis and Cost Management
ABC analysis assigns items to either the A, B, or C category. A items are high-dollar items,
B are medium-dollar, and C are low-dollar items. From a cost management perspective,
more time and managerial attention is directed toward A items because of the percent of
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annual spend consumed by the purchase of these items. The supply manager would focus
on understanding the supplier’s cost structure to identify opportunities for either the supplier or a joint buyer-supplier initiative to eliminate, reduce, or avoid costs in any of a number of cost elements. Thinking about the supplier’s strategic positioning, A items might be
either differentiated products (customized) or low-cost commodity type items. If they are
customized, then the source of cost reductions might come from decisions inside the buying organization such as specification or design changes. If the items are commodity-type
items, then the cost reductions might come from inside the supplier’s organization and be
from its supply chain or its production process or distribution network.
Portfolio or Quadrant Analysis and Cost Management
Portfolio analysis enables a supply management team to place each major spend category
on a spend map based on the risks to acquire in the marketplace and the value of the category to the organization. Figure 11–1 provides typical characteristics of each quadrant.
The x-axis represents the assessment of risk to acquire or how easy or hard is it to acquire
a specific spend category (good or service) in the marketplace. (Also see strategy development in Chapter 12 and Figure 12–4). The Delphi Corporation case in Chapter 13 shows
how the company uses a similar framework as part of its strategic sourcing process.
The analyst should locate the spot on the map that represents the best analysis of two
dimensions. This is done by first analyzing and determining the point on one axis, then
FIGURE 11–1 Characteristics of Spend Categories
High
Bottleneck
• Unique specification.
• Supplier’s technology is important.
• Production-based scarcity due to low
demand and/or few sources of supply.
• Substitution is difficult.
• Usage fluctuates/not routinely predictable.
• Potential storage risk.
Strategic
• Continuous availability essential.
• Custom design or unique specifications.
• Supplier technology important.
• Few suppliers with adequate technical
capability or capacity.
• Switching suppliers is difficult.
• Substitution is difficult.
Noncritical/Routine
• Standard specification or commoditytype items.
• Substitute products readily available.
• Competitive supply market with many
suppliers.
Leverage/Commodity
• Unit price management is important
because of volume of usage.
• Standard specification or commoditytype items.
• Substitution is possible.
• Competitive supply market with several
suppliers.
Risk
Low
High
Low
Value
Source: Adapted from Peter Kraljic, “Purchasing Must Become Supply, Management,” Harvard Business Review, 1983.
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292 Purchasing and Supply Management
doing the same for the other axis, and then locating the point of intersection on the map.
For example, not all leverage items behave the same. A leverage item in the upper-right
corner of that quadrant is both of greater value to the organization and higher risk (harder to
acquire in the marketplace) than a leverage item (good or service) located in the lower-left
corner of the leverage quadrant.
Portfolio analysis is a category management planning tool that enables the identification
and application of price and cost analysis tools. The price analysis tools discussed in Chapter 10 are primarily used when purchasing lower risk (commodity-type items) of lower
total value to the organization. The cost tools discussed in this chapter are primarily applied
to higher-risk and higher-value purchases. A key decision in this process is the definition
of value. The original intent was for value to be defined as impact on the organization. In
practice, many users define value as percent of annual spend.
Commodity-type items of low value to the organization (noncritical or routine) are
essentially commodities. If a supplier has positioned a good or service as a cost leader, it is
essentially selling a commodity and price must be competitive. To compete aggressively on
price, the supplier must focus on continually reducing its costs. For a manufacturer these might
be production costs, carrying costs, and raw materials costs. For a service provider, these might
be labor costs or process costs. The buyer’s cost management approach might be to minimize
acquisition or order process costs and rely on market competition to keep prices competitive.
Commodity-type goods and services in the leverage quadrant are both higher value
(either more impact on the organization’s success or higher dollar value, depending on the
definition of value) and riskier to acquire. The supply manager’s goal is still to manage
costs by minimizing order processing costs. Because of the higher value of these purchases, the benefits of other cost analysis tools such as total cost of ownership may be
worth the cost of the process.
As goods and services become riskier to acquire while still of low to moderate value to
the organization (bottleneck), the supply manager’s goal may be to assure supply. Process
costs related to negotiating longer-term contracts and building stronger buyer–supplier relationships may increase along with higher carrying costs if inventory is used to assure
supply. Longer-term costs may be incurred to conduct value analysis to find less costly
ways to deliver the same function.
Strategic goods and services are both more valuable to the buying organization and
riskier to acquire. The supply manager’s goals are to assure continuous supply at the lowest
total cost of ownership. A more thorough understanding of internal cost structure and the
supplier’s cost structure may be necessary to find ways to avoid, eliminate, or reduce costs.
Portfolio analysis provides a framework for developing strategic plans for spend categories and for applying price and cost management tools.
Price analysis, addressed in Chapter 10, examines price proposals without examining
elements of cost and profit. Cost analysis reviews actual or future costs. Some supply managers believe they are not justified in going very far into suppliers’ costs. They take this
position for several reasons:
• In many cases, suppliers do not know their costs, and it would be useless to inquire
about them.
• The interpretation of cost calls for an exercise of judgment, and differences of opinion
would arise even if all the numbers were available.
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• Some suppliers will not divulge cost information.
• The seller’s costs do not determine market prices.
• The buyer is not interested in the supplier’s costs anyway; the primary concern is getting
the best price consistent with quality, quantity, delivery, and service.
• If a seller offers a price that does not cover costs, either in ignorance or with full
recognition of what it is doing, the matter is the seller’s problem and not the buyer’s.
However, unless a buyer has some idea of a supplier’s costs, at least in a general way,
it is difficult to judge the reasonableness of the supplier’s prices. Furthermore, the position
that the buyer is neither concerned with, nor responsible for, suppliers who offer merchandise below cost must recognize two things: First, good suppliers need to cover their costs
to survive and prosper; and, second, prices may subsequently rise materially above cost as
suppliers fight for financial survival.
The party in the strongest position in a negotiation session is the one with the best data.
Recognizing the importance of cost, it is common practice for the purchaser to make the
best estimate possible of the supplier’s costs as one means of judging the reasonableness
of the price proposed. Many larger firms have cost analysts within the supply area to assist
in analyzing supplier costs in preparation for negotiation. Some companies use cost-based
pricing, a cost modeling system used by purchasers to determine total cost. These cost
estimates must be based on such data as are available.
COST MANAGEMENT TOOLS AND TECHNIQUES
Five cost management techniques are addressed in this section: total cost of ownership
(TCO), target pricing, the learning curve, value engineering and value analysis, and activitybased costing.
Total Cost of Ownership
The purchaser should estimate the total cost of ownership (TCO) before selecting a supplier.
Broadly defined, total cost of ownership for noncapital goods acquisition includes all relevant costs, such as administration, follow-up, expediting, inbound transportation, inspection
and testing, rework, storage, scrap, warranty, service, downtime, customer returns, and lost
sales. The acquisition price plus all other associated costs becomes the total cost of ownership. A total cost approach requires the cooperation of engineering, quality, manufacturing,
and supply to coordinate requirements such as specifications and tolerances that affect the
supply decision. Early supplier involvement also is essential to ensure cost-effectiveness.
TCO models attempt to determine all the cost elements, thereby revealing opportunities
for cost reduction or cost avoidance for each cost element, rather than merely analyzing or
comparing prices. The difficulty lies in identifying and tracking these cost elements and
using the information appropriately to compare different suppliers.
The concept of TCO acknowledges that acquisition price is merely one part of the costs
associated with owning a good or procuring a service. While the most obvious reason for
using TCO is to identify the actual cost of the supply decision, TCO also can be used to
1. Highlight cost reduction opportunities.
2. Aid supplier evaluation and selection.
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294 Purchasing and Supply Management
3.
4.
5.
6.
7.
8.
Provide data for negotiations.
Focus suppliers on cost reduction opportunities.
Highlight the advantage of expensive, high-quality items.
Clarify and define supplier performance expectations.
Create a long-term supply perspective.
Forecast future performance.
There are a number of methods for estimating the total cost of ownership. Each firm
must develop or adopt a method of cost modeling that best fits the needs of the organization. In close buyer–supplier relationships, the seller may willingly share cost data with
the buyer. In other situations, the buyer or sourcing team may have to develop its own cost
model to prepare for negotiations. There are many approaches to cost modeling, from informal ones to highly sophisticated, complex computer models. Firms typically use either
standard cost models, which are applied to a variety of supply situations, or unique cost
models, which are developed for a specific item or situation.1
One way of analyzing cost elements is demonstrated by a model that refers to three
cost components: (1) pretransaction costs (e.g., identifying need, qualifying sources, and
adding supplier to internal systems); (2) transaction costs (e.g., purchase, inspection, and
administrative costs); and (3) post-transaction (e.g., defective parts, repairs, and maintenance).2 The acquisition price is broken down into the individual cost elements from which
the price is derived. Each of these cost elements then can be analyzed by the buyer for areas
of reduction or avoidance. Cost elements are both tangible and intangible, meaning that
many are difficult to estimate.
Manufacturing Cost Elements
The following section addresses the typical cost elements of a manufactured product and
provides suggestions for estimating the cost of each.
The prices of raw material entering into the product are commonly accessible and the
amounts required are also fairly well known. Material costs can be estimated from a bill
of material, a drawing, or a sample of the product. The buyer can arrive at material costs
by multiplying material quantities or weight per unit by raw material prices. Sometimes a
material usage curve will be helpful. The purpose of the curve is to chart what improvement should occur from buying economies and lower scrap rates as experience is gained in
the manufacturing process. Use of price indexes and maintenance of price trend records are
standard practice. For component parts, catalog prices often offer a clue. Transportation
costs are easily determined.
Overhead costs generally consist of indirect costs incurred in the manufacturing, research, or engineering facilities of the company. The buyer’s own engineers should provide
data on processing costs. Equipment depreciation typically is the largest single element in
manufacturing overhead. It is important to know how these overhead costs are distributed
to a given product. If overhead is allocated as a fixed percentage of direct labor costs and
1
Lisa Ellram, “A Taxonomy of Total Cost of Ownership Models,” Journal of Business Logistics, vol. 15,
no. 1, 1994, pp. 171–191.
2
Lisa Ellram, “Total Cost of Ownership: Elements and Implementation,” International Journal of Purchasing and Materials Management, Fall 1993.
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there is an increase in labor costs, overhead costs can be unduly inflated unless the allocation percentage is changed. General overhead rates can be approximated.
The growing tendency for industry to become more capital intensive has increased the
relative percentage of overhead versus direct labor and materials. Because some items in
the overhead, such as local real estate taxes, are attributable to the location of the supplier
and others are properly seen as depreciation or investment at varying technological and
economic risk levels, the analysis and allocation of these costs to individual products are
particularly difficult.
Both tooling costs and engineering costs often are included as a part of general manufacturing overhead, but it is wisest to pull them out for analysis as separate items since
each may account for a relatively large amount of cost. The buyer wants to know what it
should cost a reasonably efficient supplier to build the tooling and own the completed tooling, what its life expectancy (number of units) is, and whether the tooling can be used with
equipment other than that owned by the supplier. Only with such information can the buyer
guard against being charged twice for the same tooling.
General and administrative expense includes items such as selling, promotion, advertising, executive salaries, and legal expense. Frequently there is no justification for the supplier
to charge an advertising allocation in the price of a product manufactured to the buyer’s
specifications or after entering into a long-term buyer-supplier partnering relationship.
Direct labor estimates are not made as easily as material estimates. Even though labor
costs are normally labeled direct for machine operators and assembly-line workers, in reality they tend to be more fixed than most managers care to admit. Most organizations prefer
not to lay off personnel, and there are strong pressures to keep the so-called direct labor
force reasonably stable and employed. This means that inventories and overtime often are
used to smooth fluctuations in demand and also that labor cost becomes at least semivariable and subject to allocation.
Product mix, run sizes, and labor turnover may affect labor costs substantially. The
greater the mix, the shorter the lot size produced, and the higher the turnover, the greater
the direct labor costs will be. These three factors alone may create substantial cost differences between suppliers of an identical end product. Geographical considerations also play
a large part because differences in labor rates do exist between plant locations. Such differences may change dramatically over time, as the rapid increases in direct labor rates in
Japan and Germany have demonstrated. The astute cost analyst will estimate the supplier’s
real labor costs, taking the above considerations into account.
Services Cost Elements
As addressed in Chapter 6 “Need Identification,” services are intangible products that may
or may not be bundled with a good. A service provider does not have costs of manufacturing and the accompanying carrying costs for raw materials, work-in-process, and finished
goods inventory. The primary cost elements for a service provider are direct and indirect
labor depending on whether the service is high or low labor intensive.
Overhead costs generally consist of indirect costs incurred in the design, development,
delivery, and operational facilities of the company. The buyer’s own operations should
provide data on processing costs. Depending on the type of service provider, equipment
depreciation may be a very small part of overhead. Labor intensity will affect the relative
percentage of overhead versus direct labor.
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General and administrative expense includes items such as selling, promotion, advertising, executive salaries, and legal expense. Frequently there is no justification for the supplier
to charge an advertising allocation in the price of a service designed to the buyer’s specifications or after forming a long-term buyer-supplier partnering relationship. Transportation
costs, in the form of Travel and Entertainment (T&E), may be high depending on the amount
and geographical range of travel in support of sales and customer relationship management.
These costs may be easily determined if the service provider has consolidated and manages
this spend category. Or these costs may be hidden if responsibility for travel spend is highly
decentralized. While travel spend is often targeted for cost reduction, starkly different perspectives on cost-cutting opportunities are likely to be offered by users and cost-cutters.
Direct labor for a service contract includes the supplier’s employees whose time is
directly engaged to perform an identifiable task required under the terms of the contract. This
task may or may not result in a tangible output, for example an architectural drawing, depending on the nature of the service provided. Most organizations prefer not to lay off personnel,
and there are strong pressures to keep the so-called direct labor force reasonably stable and
employed. This means that overtime often is used to smooth fluctuations in demand and also
that labor cost becomes at least semivariable and subject to allocation.
In high labor intensity services, the cost of managing multiple sources for the same
service or the costs of switching suppliers may be very high. These costs include resolving
contractual issues, knowledge-transfer costs, licensing fees, initial setup and training costs
with a new supplier, and the internal resources to manage the process. These costs may be
underestimated when initial sourcing decisions are made.
Services mix, length of service contract, location of service provision (supplier’s site or
buyer’s site and onshore, near shore, or offshore) and labor turnover may affect labor costs
substantially. The greater the mix, the shorter the contract term, the higher the labor rate,
and the higher the turnover, the greater the direct labor costs will be. Geographical considerations also play a large part because differences in labor rates exist between locations.
Labor savings is a prime driver of the trend to outsource and offshore a growing variety
of services. Labor differentials may change dramatically over time, as the recent rapid increases in direct labor rates in certain job categories in India and China demonstrated. The
same thing occurred in Japan and Germany in the past. The astute cost analyst will estimate
the supplier’s real labor costs, taking the above considerations into account.
There are several opportunities for buyers of services to reduce, contain, and avoid cost
in services contracts. These include:3
1.
2.
3.
4.
5.
6.
7.
8.
Usurping procurement leverage.
Hidden cost adders.
Cost of money.
Billing and calculation errors.
Substitution of lower-skilled staff or inputs.
Providing levels of service below commitment.
Bundling of services with other services or goods.
Summary invoicing.
Lisa M. Ellram, Wendy L. Tate, and Corey Billington, “Understanding and Managing the Services Supply
Chain,” The Journal of Supply Chain Management 40, no. 4 (2004), p. 17.
3
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Based on this list, many of the cost-saving, reduction, and avoidance opportunities in services come from improving operating efficiency and productivity rather than better design.
Frequently, in highly professional services the cost of the professional service may be
relatively low compared to the benefit expected. For example, a good design may increase
sales substantially; a good architect may be able to design a low-cost but effective structure; and a good consulting recommendation may turn around a whole organization. It
often is difficult to deal with this trade-off between the estimated costs for the job versus
the estimated benefits. Some supply managers are working to develop cost models for
highly skilled service providers to better understand the service providers’ cost structure
and identify opportunities to lower costs.
Services involving largely lower- to medium-skilled people may focus more on cost minimization and efficiency. Services requiring highly skilled individuals may require the purchaser to
distinguish between levels of professional skill and may require extensive ongoing communication between requisitioner and supply manager through all phases of the acquisition process. It
is important to clearly define the quantity of each skill level required for successful delivery of
the service and to match that skill level with the price and total cost of the project. For example,
if a paralegal can perform the service at the quality level desired, then there may be no reason
to pay the hourly cost of a partner in a high-level law firm.
Cost management of services often starts with demand management, also referred to as
consumption management in some industries. An internal review analyzes consumption
patterns to determine what, if any, changes can be made to consumption of the service.
These include eliminate the service, reduce the volume of the service, reduce the frequency
of the service, change the specification; find a substitute; improve the purchasing process
to eliminate maverick buying; reduce overconsumption, rationalize the supply base; consolidate spend; and standardize the price, terms, and conditions.
Understanding the cost structure of professional service providers is important as more
highly professional service providers offshore aspects of their business. For example, U.S.
law firms offshore legal work, consulting firms offshore analytical work, and hospitals
offshore the interpretation of medical tests. Should a client of these service providers share
in the labor savings realized by these decisions? Do these offshoring decisions raise other
issues about quality and costs?
Life-Cycle Costing and Capital Goods Acquisition
Life-cycle costing (LCC) is the term for TCO used in capital acquisitions. It is an appropriate decision approach to capital investments in which the price of the capital good may be
dwarfed by the other costs associated with owning, operating, and disposing of the item.
The philosophy behind LCC is the same as TCO. The total cost of a piece of equipment
goes well beyond the purchase price or even its installed cost. What is really of interest is
the total cost of performing the intended function over the lifetime of the task or the piece
of equipment. Thus, an initial low purchase price may mask a higher operating cost, perhaps occasioned by higher maintenance and downtime costs, more skilled labor, greater
material waste, more energy use, or higher waste processing charges. Since the low bid
would favor a low initial machine cost, an unfair advantage may accrue to the supplier with
possibly the highest life-cycle cost equipment.
It is the inclusion of every conceivable cost pertaining to the decision that makes the
LCC concept easier to grasp theoretically than to practice in real life. Since many of the
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costs are future ones, possibly even 10 to 15 years hence and of a highly uncertain nature,
criticisms of the exactness of LCC are well founded. Fortunately, computer programs are
available varying from simple accounting programs, which compute costs from project
life cycles, to Monte Carlo simulation of the equipment from conception to disposal. The
software allows for testing of sensitivity, and, when necessary, inputs can be changed readily. In one total cost of ownership study for a multimillion-dollar piece of equipment, 139
different cost elements were identified for the computer simulation of the process.
LCC is a serious and preferable alternative to emphasizing the selection of low bids,
particularly in governmental purchasing. The experience with LCC has shown in a surprising number of instances that the initial purchase price of equipment may be a relatively low
percentage of LCC. For example, the price paid for computers seldom accounts for over
50 percent of LCC, and most industrial equipment falls into the 20 to 60 percentage range.
However, price is often the major factor in an acquisition decision. This is easy to
understand when the number and variety of cost elements and the difficulty in calculating these costs are considered. The fundamental questions about cost elements for capital
goods include the following:
•
•
•
•
•
•
•
•
•
•
•
•
•
Is the equipment intended for replacement only or to provide additional capacity?
What is the installed cost of the equipment?
What will startup costs be?
Will its installation create problems for plant layout?
What will be the maintenance and repair costs?
Who will provide repair parts and at what cost?
Are accessories required and, if so, what will their costs be?
What will be the operating costs, including power and labor?
What is the number of machine-hours the equipment will be used?
Can the user make the machine or must it be bought outside?
At what rate is the machine to be depreciated?
What financing costs are involved?
If the equipment is for production, what is the present cost of producing the product
compared to the cost of obtaining the product from an outside supplier?
• If the equipment is for production, what is the projected cost of producing the product
compared to the cost of obtaining the product from an outside supplier?
For example, in the semiconductor industry, capital equipment purchases normally represent the largest single percentage category of all purchase dollars. At Intel the goal is to
tie capital equipment purchasing and equipment service to performance-based contracting.
Thus, the supplier gets paid for uptime and quality output. The more the running time
exceeds agreed-to output goals, the greater the rewards for the supplier. Future plans are
driven by the need for continuous improvement in cost per wafer and number of wafers
per year per machine. Only a few key supplier partners are included in Intel’s longer-range
technology road maps planning process––looking five years out. Total cost of ownership,
not just the cost of the equipment itself, drives future technology decisions. Obviously,
the corporate team approach is required to manage this process, and exceptionally capable
individuals need to represent supply on the corporate team.
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Target Pricing
Target pricing is experiencing growing use in North America. Target pricing focuses the
attention of everyone in the organization on designing costs out of products and services
rather than on eliminating costs after production has begun or services have been delivered.
This concept is a logical extension of the quality movement’s basic premise that it makes
sense to build something right the first time. Basically, in target pricing, the organization
establishes the price at which it plans to sell its finished product, then subtracts out its
normal operating profit, leaving the target cost that the organization seeks. The target cost
is then further subdivided into appropriate cost sectors, such as manufacturing process,
overhead, materials, and services. Supply becomes responsible for working with suppliers
to achieve the materials and services target.
For example, if the end product is a manufactured item that will be sold for $200, and
purchased goods represent 60 percent of each dollar in sales revenue, then supply would be
responsible for $120 of the $200 selling price. If it is determined that a 10 percent reduction
in price is desirable because of the expected impact on sales revenue, then supply would
be responsible for securing a 10 percent reduction in its portion of the costs ($120) of the
item, or $12. This means purchased materials, on a unit basis, should not exceed $108. This
becomes the target materials cost in the pricing structure. See the example in Figure 11–2.
Target pricing results in companywide cost reductions in:
1. Design to cost, on the part of design engineering.
2. Manufacture to cost, on the part of production.
3. Purchase to cost, on the part of supply.
Implications for Supply Management
For supply, target pricing can be beneficial by providing a means of documenting specific
price reductions needed from suppliers, demonstrating supply’s contribution to the pricing
goals of the firm, and documenting supply’s contribution on a product-by-product basis.
FIGURE 11–2
Future market price – Desired profit Target cost
Target Pricing
Example
Adjust for spec.
differences
Part/system price
Current profit
Desired profit
Current
cost
Modeltomodel
change
Internal
costs
C
Target
cost
B
Purchased
component
part level
costs
A
Current price
joh77899_ch11_288-312.indd 299
Verified by
cost standards
Component
target costs
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300 Purchasing and Supply Management
To be effective, target pricing works best when the customer has clout in the supply chain;
when there is loyalty between buyer and seller, as in a partnering arrangement or alliance;
and when the supplier also stands to benefit from the cost reductions.
The cost reductions on the part of the supplier conceivably can come from several areas:
The supplier can seek reductions in overhead expenses and/or general, selling and administrative expenses; the supplier can improve efficiencies in labor as measured by the learning
curve; or the supplier can seek labor cost reductions and material cost reductions from its
supply chain. This last option requires the supplier to pass down these techniques to its
suppliers in the supply chain.
Overall, target pricing provides supply with:
(1) a measurable target for supply performance,
(2) a yardstick for measuring cost reductions, and
(3) a means of measuring the supplier’s efficiency.
As with all cost analysis tools, the expected benefits from the target-costing process
must exceed the costs associated with conducting the analysis.
Target pricing cannot occur in a vacuum. To be successful, the effort requires crossfunctional team efforts, early supplier and early supply involvement, concurrent engineering, and value engineering. In a CAPS study, The Role of Supply Management in Target
Costing, the companies participating in the study reported that they used target costing
to increase competitiveness, increase cooperation with suppliers and get earlier supplier
involvement, and improve cost management.4
The Learning Curve or Manufacturing Progress Function
The learning curve provides an analytical framework for quantifying the commonly recognized principle that one becomes more proficient with experience. Its origins lie in the aircraft
industry in World War II when it was empirically determined that labor time per plane declined dramatically as volume increased. Subsequent studies showed that the same phenomenon occurred in a variety of industries and situations. Although conceptually most closely
identified with direct labor, most experts believe the learning curve or manufacturing progress
function is actually brought about by a combination of a large number of factors that includes:
1.
2.
3.
4.
5.
6.
7.
8.
9.
The learning rate of labor.
The motivation of labor and management to increase output.
The development of improved methods, procedures, and support systems.
The substitution of better materials, tools, and equipment, or more effective use of
materials, tools, and equipment.
The flexibility of the job and the people associated with it.
The ratio of labor versus machine time in the task.
The amount of preplanning done in advance of the task.
The turnover of labor in the unit.
The pressure of competition to do tasks better, faster, and cheaper.
We know the manufacturing progress function happens; its presence has been empirically determined a sufficient number of times that its existence is no longer in doubt.
4
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Lisa M. Ellram, The Role of Supply Management in Target Costing (Tempe, AZ: CAPS Research, 1999).
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Cost Management 301
The learning curve has tremendous implications for cost determination and negotiation. For example, take a 90 percent learning curve. The progress is logarithmic. Every
time the volume doubles, the time per unit drops to 90 percent of the time per unit at half
the volume. Suppose we wish to purchase 800 units of a highly labor-intensive, expensive
product that will be produced by a group of workers over a two-year period. The 100th unit
has been produced at a labor time of 1,000 hours. With a 90 percent learning curve, the
labor time for the 200th unit would drop to 900 hours and the 400th unit to 90 percent of
900 hours, or 810 hours per unit.
It is important to recognize that the choice of learning curve, be it 95, 90, 85, or 80 percent or any other figure, is not an exact science. Normally, fairly simple tasks, like putting
parts into a box, tend to have a learning curve close to 95 percent. Medium-complexity
tasks often have learning curve rates between 80 and 90 percent, while highly complex
tasks tend to be in the 70 to 80 percent range.
The learning curve implies that improvement never stops, no matter how large the volume becomes. The potential of the learning curve in supply management has not yet been
fully explored. It is a powerful concept. Progressive discounts, shortened lead times, and
better value can be planned and obtained through its use. The learning curve is used along
with target pricing to set progressively lower price targets for future deliveries.
Value Engineering and Value Analysis
Value methodology is a systematic approach to analyzing the functions of a product, part,
service, or process to satisfy all needed quality and user requirements at optimum total cost
of ownership.Value can be expressed as:
Function
VALUE Cost
The goal is to perform a function at the same or an improved level while reducing costs. The
focus is on functional analysis. Unnecessary costs, those that do not provide quality, extend
product or service life, or provide features desired by customers, can be avoided or eliminated.
Value engineering (VE) refers to the application of this analytical process to the design
stage of a product or service; value analysis (VA) to the redesign of a product or service. By focusing on function and cost in the design stage, unnecessary costs can be avoided. In the redesign stage, the organization has already incurred costs that must now be reduced or eliminated.
Lower total cost of ownership is achieved when a cost management focus starts in design.
Activity-Based Costing
Traditional cost accounting introduces distortions into product costing because of the way
it allocates overhead on the basis of direct labor. In the past, when labor costs often were
the largest cost category, this allocation made sense. However, as the cost of materials
has eclipsed labor costs as the single largest cost factor, accountants have looked for other
ways to allocate overhead.5 Basically, activity-based costing (ABC) tries to turn indirect
costs into direct costs by tracking the cost drivers behind indirect costs.
One of the biggest hurdles in ABC is the cost of tracking indirect costs and translating
them into direct costs, compared with the benefits of being able to assign these costs to
The section is drawn largely from John C. Lere and Jayant V. Saraph, “Activity-Based Costing for Purchasing Managers’ Cost and Pricing Determinations,” International Journal of Purchasing and Materials
Management, Fall 1995, pp. 25–21.
5
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302 Purchasing and Supply Management
specific products more accurately. In ABC, manufacturing overhead is divided into costs
that change in response to unit-level activities (in proportion to the number of units produced), batch-level activities (in proportion to the number of batches produced), and product-level activities (that benefit all units of a product). The remainder are true fixed costs
and are allocated the same way as in traditional cost accounting.
It is easy for those trying to apply the ABC concept to collect too much detail and be
unable to make much sense out of it. Even so, it is a powerful tool that has many implications for supply management.
Implications for Supply Management
Buyers can use activity-based costing as a tool to reduce supplier costs by
• Eliminating: nonvalue-adding activities.
• Reducing activity occurrences.
• Reducing the cost driver rate.
To accomplish these goals, buyers must collect data from suppliers on activities (specific tasks), cost drivers (a metric to measure activity), cost driver rates (rate at which cost
is incurred), and units of cost driver (the amount of activity). Buyers then can determine
which activities add value and should occur, and which do not add value and should be
eliminated. Even if an activity is deemed value-adding, it may be possible to reduce the
number of times the activity occurs, thereby reducing cost.
For example, receiving inspection may be rated as nonvalue-adding and targeted for elimination, or it may be deemed value-adding but the number of receipts requiring inspection may
be reduced, thereby reducing costs. Lastly, the cost of the activity itself may be targeted as an
area for improvements in efficiency through value analysis and system redesign.
Assigning cost estimates to activities is often difficult. It is essential, however, to enable
comparison of activities and activity levels and to determine where improvements contribute most to organizational performance. Competing goals and objectives of different
functional areas may increase the difficulty of using ABC as a decision-making tool. In the
example above, receiving may use ABC to decrease incoming inspections and improve
receiving department performance. Quality assurance, however, may want to increase incoming inspection to reduce acceptance rates of nonconforming product.
NEGOTIATION
Negotiation is the most sophisticated and most expensive means of price determination.
Negotiation requires that the buyer and supplier, through discussion, arrive at a common
understanding on the essentials of a purchase/sale contract, such as delivery, specifications,
warranty, prices, and terms. Because of the interrelation of these factors and many others, it
is a difficult art and requires the exercise of judgment and tact. Negotiation is an attempt to
find an agreement that allows both parties to realize their objectives. It must be used when
the buyer is in a single- or sole-source situation; both parties know that a purchase contract
will be issued, and their task is to define a set of terms and conditions acceptable to both.
Because of the expense and time involved, true negotiation normally will not be used unless the dollar amount is quite large.
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Cost Management 303
Negotiating a fair price should not be confused with price haggling. Supply managers
generally frown on haggling and properly so, for in the long run the cost to the buyer far
outweighs any temporary advantage. For a purchaser to tell a sales representative that he
or she has received a quotation that was not, in fact, received or that is not comparable; to
fake telephone calls in the sales representative’s presence; to leave real or fictitious bids
of competitors in open sight for a sales representative to see; to mislead as to the quantity
needed—these and similar practices are illustrations of those unethical actions so properly condemned by the codes of ethics of the Institute for Supply Management (ISM), the
Purchasing Management Association of Canada (PMAC), and other supply associations
around the world.
Negotiation need not result in a lower price. Occasionally, there may be revision upward of the price paid, compared with the supplier’s initial proposal. If, in the negotiation,
it becomes clear that the supplier has either misinterpreted the specifications or underestimated the resources needed to perform the work, the buyer will bring this to the supplier’s
attention so the proposal may be adjusted accordingly. A good contract is one that both
parties can live with, and under which the supplier should not lose money, providing its
operation is efficient. When a purchaser cooperates in granting increases not required by
the original supplier proposal, the buyer then is in a position to request decreases in prices
if unforeseen events occur that result in the supplier’s being able to produce the material or
product at a substantial savings.
Negotiation Strategy and Practice
Reasonable negotiation is expected by buyer and seller alike. It is within reasonable bounds
of negotiation to insist that a supplier
1.
2.
3.
4.
5.
Operate in an efficient manner.
Keep prices in line with costs.
Not take advantage of a privileged position.
Make proper and reasonable adjustment of claims.
Be prepared to consider the special needs of the buyer’s organization.
While negotiation normally is thought of as a means of establishing the price to be paid,
and this may be the main focus, many other areas or conditions can be negotiated. In fact,
any aspect of the purchase/sale agreement is subject to negotiation.
The discussion of some of the elements and considerations that affect the price of an
item makes it obvious that negotiation can be a valuable technique to use in reaching an
agreement with a supplier on the many variables affecting a specific price. This is not to say
that all buying/selling transactions require the use of negotiations. Nor is the intention to
indicate that negotiation is used only in determining price. Reaching a clear understanding
of time schedules for deliveries, factors affecting quality, and methods of packaging may
require negotiations of equal or greater importance than those applying to price.
A list of some of the various kinds of purchasing situations in which the use of negotiations should prove valuable follows:
1. Any written contract covering price, specifications, terms of delivery, and quality
standards.
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304 Purchasing and Supply Management
2. The purchase of items made to the buyer’s specifications. Special importance should
be attached to “first buys,” because thorough exploration of the needs of the buyer and
the supplier often will result in a better product at a lower price.
3. When changes are made in drawings or specifications after a purchase order has been
issued.
4. When quotations have been solicited from responsible bidders and no acceptable bids
have been received.
5. When problems of tooling or packaging occur.
6. When changing economic or market conditions require changes in quantities or
prices.
7. When problems of termination of a contract involve disposal of facilities, materials,
or tooling.
8. When there are problems of accepting any of the various elements entering into costtype contracts.
9. When problems arise under the various types of contracts used in defense and governmental contracting.
10. When cost analysis shows a significant gap between market price and costs.
Framework for Planning and Preparing for Negotiation
Success in negotiation largely is a function of the quality and amount of planning that has
been done. Figure 11–3 presents a model of the negotiation process.
The basic steps in developing a strategy for negotiation are
1. Develop the specific objectives (outcomes) desired from the negotiation. This is done
by gathering relevant information and than generating, analyzing, evaluating, and
selecting alternatives.
2. Gather pertinent data. Here is where cost analysis comes into play.
3. Determine the facts of the situation. A fact is defined as an item of information about
which agreement is expected. For example, if the supplier’s cost breakdown states that
the direct labor rate is $20.10 per hour, and you agree, that is a fact.
FIGURE 11–3
Establish:
Determine:
OBJECTIVES
Model of the
Negotiation
Process
Issue
Maximum
Target
Minimum
Issue
Maximum
Target
Minimum
Issue
Maximum
Target
Minimum
Fact
Fact
Fact
Fact
joh77899_ch11_288-312.indd 304
Set range and target:
Plan:
Negotiation
strategy
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Cost Management 305
4. Determine the issues. An issue is something over which disagreement is expected. The
purpose of negotiation is to resolve issues so that a mutually satisfactory contract can be
signed. For example, if the supplier claims the manufacturing burden rate is 300 percent
of direct labor costs, but your analysis indicates a 240 percent burden rate is realistic,
this becomes an issue to be settled through negotiation.
5. Analyze the positions of strength of both (or all) parties. For example, what are the
supplier’s capacity, backlog, and profitability? How confident is the supplier of getting the contract? Is there any time urgency? The process of analyzing strengths helps
the negotiator establish negotiation points, helps avoid setting unrealistic expectations,
and may reveal ideas for strategies. The negotiator (or team) should be able to generate a list of 12 to 24 points for either side through a brainstorming process.
6. Set the buyer’s position on each issue and estimate the seller’s position on each issue
based on your research. What data will be used to support the buyer’s position? What
data might support the seller’s position? Two questions should be asked after analyzing positions of strength: (a) “Whose position is stronger?” and (b) “Which points
give each side the most strength?” The answer to the first question should help determine how realistic the objectives are and if they need to be changed or clarified. The
answer to the second question tells the negotiator what his or her key points will be in
the negotiation and what to expect from the other side. If done well, this information
allows the negotiator to prepare counterarguments.
By estimating the range of acceptable results for both buyer and seller, the negotiator
can determine, first, if there is a zone of overlap, meaning negotiation is feasible and
likely to result in an agreement; or, second, if there is a gap between the objectives of
the parties (see Figure 11–4). If there is a gap, the negotiator must determine if it can
be closed, and if not, whether negotiation even makes sense in this particular situation.
FIGURE 11–4
1. The seller and purchaser overlap.
The Zone of
Negotiation
The seller's range:
$240,000 to $280,000
Zone of
Negotiation
$220,000
$240,000
$250,000
$280,000
The purchaser's range:
$220,000 to $250,000
2. The seller and purchaser do not overlap.
The gap
$220,000
$250,000
The purchaser's range:
$220,000 to $250,000
joh77899_ch11_288-312.indd 305
$270,000
$300,000
The seller's range:
$270,000 to $300,000
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306 Purchasing and Supply Management
7. Plan the negotiation strategy. Which issues should be discussed first? Where is the
buyer willing to compromise? Who will make up the negotiation team (it frequently
is composed of someone from both engineering and quality control for a good, or the
primary internal consumer for a service, headed by the buyer)? Establishing a range
and a target for each objective sets reasonable objectives that the negotiator feels
can be achieved. The tactics used in the actual negotiation may mean starting out at
a more extreme position than the negotiator truly believes is achievable. The decision about tactics should be based on the negotiator’s understanding of the situation
and the parties involved in the negotiation. If the goal of negotiation is performance,
then the way negotiation is conducted is important because it affects the intention to
perform. If the tactics used leave the other party feeling negative toward the negotiator or the results, there may be little commitment to the agreement or to solving any
problems that might arise during the life of the contract.
8. Brief all persons on the team who are going to participate in the negotiations.
9. Conduct a dress rehearsal for the people who are going to participate in the
negotiations.
10. Conduct the actual negotiations with an impersonal calmness.
All negotiation has an economic as well as a psychological dimension. It is important
to satisfy both of these dimensions to achieve a win-win result. The trends toward teaming, single sourcing, partnering, and empowerment reinforce the need for supply personnel
to be superior negotiators, both with suppliers and with others in their own organization.
Actually, negotiations inside one’s own organization to obtain cooperation and support for
supply initiatives may be more challenging than those with suppliers.
Conclusion
joh77899_ch11_288-312.indd 306
The notion that an attempt should be made to identify and analyze all costs of ownership
drives many of the supply strategies discussed in this book. For example, long-term,
collaborative buyer–supplier relationships; partnering arrangements and alliances; and
early supplier and supply involvement all can facilitate total cost modeling, improve
negotiations and decision making, and result in increased competitiveness for the
organization.
Supply professionals concerned with contributing effectively to organizational goals
and strategies need to be concerned with managing costs instead of prices. Beating up suppliers for unreasonable price concessions can be as damaging as “leaving too much on the
table” in a negotiation with an important supplier. Understanding where and how supply
chain costs can be reduced or eliminated can represent an opportunity to gain competitive
advantage.
Negotiation and supplier cost analysis complement each other. Cost analysis identifies the opportunity and secures the result. Costs drive pricing, and negotiations with
suppliers that concentrate on costs focus both parties on opportunities to improve competitiveness as opposed to posturing around prices and win/lose bargaining. The skilled
supply professional not only understands the value of reliable supplier cost data but is
also resourceful in collecting such information and capable of using it effectively in a
negotiation.
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Cost Management 307
Questions
for
Review
and
Discussion
1. What is cost-based pricing? How and why is it used?
2. What are the major cost categories that you would include when estimating a
supplier’s cost for a manufacturing item? How would you estimate such costs if the
supplier was either unwilling or unable to provide a detailed cost breakdown?
3. What are the major cost categories that you would include when estimating a supplier’s cost for a service? How would you estimate the cost if the supplier was either
unwilling or unable to provide a detailed cost breakdown?
4. When, and how, is negotiation used, and what can be negotiated?
5. What is a learning curve and how can it be used?
6. Why do firms use target pricing? How are target prices established?
7. What is activity-based costing (ABC), and how can the buyer use ABC to reduce
costs?
8. What is total cost of ownership (TCO), and how is it determined?
9. What is the difference between “managing costs” as opposed to “managing prices”?
10. Please comment on the following statement: Target pricing can only be used for
manufactured items and cannot be applied to services.
References
Cooper, R., and R. Slagmulder. Target Costing and Value Engineering. Portland, OR:
Productivity Press, and Montvale, NJ: The IMA Foundation for Applied Research Inc.,
1997.
Ellram, L. M.; W. L. Tate; and C. Billington. “Understanding and Managing the Services
Supply Chain.” The Journal of Supply Chain Management 40, no. 4 (2004), p. 17.
Ellram, L. M. The Role of Supply Management in Target Costing. Tempe, AZ: CAPS
Research, 1999.
Ellram, L. Strategic Cost Management in the Supply Chain: A Purchasing and Supply
Management Perspective. Tempe, AZ: CAPS Research, 2002.
Ellram, L. “A Taxonomy of Total Cost of Ownership Models.” Journal of Business
Logistics 15, no. 1 (1994), pp. 171–91.
Ellram, L. “Total Cost of Ownership: Elements and Implementation.” International
Journal of Purchasing and Materials Management, Fall 1993.
Ferrin, B. G., and R. E. Plank. “Total Cost of Ownership Models: An Exploratory Study.”
Journal of Supply Chain Management 38 no. 3 (2002), pp. 18–29.
Fisher, R., and D. Ertel. Getting Ready to Negotiate: The Getting to Yes Workbook. New
York: Penguin Books, 1995.
Fisher, R.; W. Ury; and B. Patton. Getting to Yes: Negotiating Agreement Without Giving
In. New York: Penguin Books, 1991.
Flynn, A. E. Consumption and Specification Management at Bristol Myers Squibb.
Practix, Tempe, AZ: CAPS Research, 2005.
Lewicki, R. J.; D. M. Saunders; and B. Barry. Negotiation. 5th ed. Burr Ridge, IL:
McGraw-Hill/Irwin, 2005.
Ury, W. Getting Past No: Negotiating Your Way from Confrontation to Cooperation. New
York: Bantam Books, 1993.
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308 Purchasing and Supply Management
Case 11–1
Deere Cost Management
On Wednesday, February 18, Jim Elsey, cost management specialist at Deere & Company in Moline, Illinois,
received a call from Glen Lowery, sales manager in the
Agricultural Products Division:
Jim, I need you to look into our costs on the gatherer
chain. Our margins have really shrunk and we need to do
something about this problem. Get back to me and let me
know what you think.
THE GATHERER CHAIN
FINANCIAL ANALYSIS
Deere & Company (Deere) manufactured and distributed a
full line of agriculture equipment as well as a broad range
of construction and forestry equipment and commercial
and consumer equipment. The company had annual sales
of $14 billion with operations in more than 160 countries.
A popular product sold by the Agricultural Products
Division was a conveyor system. Materials placed on the
front end of the conveyor sat on the gatherer chain, which
carried the material to the opposite end. The gatherer
chain was joined together in links, fastened by pins, and
included small hooks that helped to carry the material. It
sat on rollers that required regular lubrication to keep the
conveyor system in good working condition.
The Agricultural Products Division had produced
the conveyor system for several years, with only slight
modifications in its design. As standard practice for each
product, Deere sold replacement parts, including gatherer
chains, through its dealer network. It was the intention of
management to ensure that its aftermarket products were
price competitive. As a result, the sales department regularly benchmarked pricing for its products.
Jim learned that the gatherer chain was purchased from
Saunders Manufacturing (Saunders), a supplier located in
Decatur, Illinois. Saunders was a family-owned business
run by Wayne Saunders, the son of the company’s founder.
Saunders had a long-term relationship with Deere, and
EXHIBIT 1
Profitability
Analysis for
Gathered
Chain
joh77899_ch11_288-312.indd 308
Aftermarket price
Purchase cost
Cost–price ratio
Unit sales
Wayne had a reputation as a tough, successful businessman who had grown the company to the point where it
now employed approximately 300 people.
Reviewing the sales margin for the gatherer chain, Jim
could see why Glen was concerned. Over the past three
years, the sales revenue and margin had been declining
steadily (see Exhibit 1). The budgeted selling price for the
current year was based on the need to match the price set
by a major competitor.
Jim arranged a meeting the following day with Susan Tessier, from purchasing, and Jose da Costa, from engineering. During the meeting, Jim laid a gatherer chain on the
conference room table and asked Jose to estimate the raw
material content. After a little bit of work, Jose estimated
that the product consisted of approximately 11.6 pounds of
steel and 46 pins that joined the links. He also expected that
Saunders would have approximately a 20 percent scrap rate,
for steel only, as part of their normal production cost. Jose
also commented that Saunders could use general-purpose
equipment for the manufacturing and assembly process.
Susan then pulled out her material cost file and made
the following observations:
We just finished negotiations with our steel suppliers and
expect to pay approximately $28.00 per hundredweight
for this type of material. I am also buying the same pins
for a couple of our divisions, and I figure Saunders is
paying about 3.5¢. Don’t forget that for this part we pay
the freight, which usually costs about 3 percent of the
purchase price, and they pay the packaging.
We have looked around for other suppliers for this
part and haven’t been able to find anyone that capable of
beating the current price. Saunders has been a good supplier. Their quality and on-time delivery performance have
been excellent. I wouldn’t want to lose them as a supplier.
Two Years Ago
Last year
Current Year
Budget
$ 40.00
$ 21.25
53%
475,000
$ 36.25
$ 22.61
62%
410,000
$ 30.00
$ 24.12
80%
350,000
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Chapter 11
Following the meeting, Jim examined the Annual Survey of Manufacturers, published by the U.S. Department
of Commerce. Within the report was a breakdown of manufacturing costs, as a percentage of sales, for U.S. companies in Saunders’ industry code. According to data from
the previous year, the breakdown was material, 42 percent; direct labor; 13 percent; indirect labor, 6 percent;
and overhead, 20 percent.
SUPPLIER NEGOTIATION
Glen felt that the budgeted cost–price ratio for the gatherer chain was unacceptable and was anxious to see what
could be done to address the problem. He remarked to
Cost Management 309
Jim, “The competition is pretty strict about maintaining
a 50–50 cost–price ratio on their product lines. Why is it
they can sell this product for $30.00 and we can’t match
their cost structure?”
Jim felt that he had gathered enough information to
do some preliminary analysis. However, he was aware
that he needed to think about how he could use the
information in his negotiation with the vendor. Susan
had indicated that Wayne Saunders had been a tough
negotiator, with a “take it or leave it” attitude regarding pricing, and had been unwilling to share any specific cost information to justify his requests for price
increases.
Case 11–2
McMichael Inc.
Art Flynn, packaging buyer for McMichael Inc. (MI),
was working on an import substitution project involving
a local minority supplier. He was concerned, however,
that his efforts would be fruitless because his original proposal had been flatly rejected by the plant manager as too
expensive.
McMichael Inc., a medium-sized company, had over
the years specialized in prescription skin-care products,
a market niche in which it had developed an excellent
reputation. About three years ago, after extensive testing,
MI had introduced a new facial cream in a special package that allowed for precise measurement of the quantity dispersed. The container, manufactured by a French
firm for a different application, was fairly expensive at
an FOB MI’s factory cost of $0.36. What concerned Art
Flynn even more, however, were the quality and delivery
problems encountered. Communications with the manufacturer were difficult, and Art had the impression the
manufacturer did not seem to care much about MI’s business, which, as Art knew, was only a small proportion of
their total volume produced.
With the cooperation of MI’s marketing, engineering, production, and quality control personnel, Art had
found a local minority supplier who appeared capable of
meeting MI’s requirements. This custom molding firm,
OSA Inc., was owned by Bert Wood, a bright engineer,
who had purchased the firm several years earlier when
joh77899_ch11_288-312.indd 309
the previous owner wished to retire. OSA Inc. had its
own tool and die manufacturing operation as well as its
own molding shop. It depended heavily on automotive
contracts, a situation Bert Wood wished to correct by
acquiring more nonautomotive business. In conjunction with MI’s engineers, Bert Wood had worked out
a mold design for the cream dispenser and included
several suggestions for minor improvements. The cost
of the mold was $56,000, an investment Bert Wood
was in no position to make and that MI would have to
absorb up front. Bert Wood quoted a unit price of $0.27
based on purchase quantities of 30,000 units at a time
and an annual volume estimated at 300,000 units. Bert
Wood had submitted a cost breakdown of this quote
as follows:
Resin
Labor
Overhead*
16¢
3¢
8¢
27¢
*Overhead breakdown:
Power
Depreciation
Interest
Space, insurance, light
and heat, taxes, supervision
1¢
1¢
3¢
3¢
6/9/10 10:00 PM
310 Purchasing and Supply Management
When Art submitted this quote along with the request for
a $56,000 mold investment up front, the plant manager and
treasurer both turned it down, arguing that the 24-month payback on the mold was far too long and that the company had
better investment opportunities with a 12-month payback.
Art was disappointed, because he had hoped this project would assist in helping him meet his savings target for
the year. When he talked the idea over with his manager,
Louise Moffat, she suggested he give it another try. She
said, “I am sure that if you can get the mold payback down
to 15 months, you will get a warmer reception. There are
not that many deals around this company that pay for
themselves in one year.” She also suggested that Art talk
to marketing to see if some other products could use the
same packaging, and to the production scheduling group to
check if different production quantities could be ordered.
When Art talked to the marketing people, he found
out that the package was ideal for another product to be
introduced shortly and with an annual demand estimated
at 100,000 units. Marketing had been uneasy about using
the French package because of the difficulties encountered with it and assured Art that if he could get a reliable
domestic source, this option would be highly attractive.
The scheduling group, for a number of years, had used a
modified MRP system. When Art discussed the new package idea with them, they told him that if the new product
and the older one were to be packaged in the same package,
a total package requirement of about 40,000 units would
make sense and that the master production schedule could
easily be adjusted to run the two products in conjunction.
Art also discussed the situation with the resin supplier,
who indicated that his quote to Bert Wood had been based
on the lot size of 30,000 packages, but that a 40,000 unit
lot would fall into a new price bracket 5 percent lower
than the originally quoted price.
Art wondered just what effect all of this new information would have on his original proposal. He knew that
Bert Wood had been adamant about his $0.27 quote. Bert
Wood had said, “I know I am classified as a minority
supplier. But I don’t want to hide behind that fact. I want
no special favors from any of my customers. Nor am I
in a position to make special gifts to anyone else. I have
had to borrow at what I consider to be ridiculously high
interest rates to buy this company. Now I have to make
it pay off. My $0.27 price is as low as I can go, as far as
I can see.”
Case 11–3
City of Granston*
On November 25, Ted Barton, the new purchasing manager at the City of Granston in Canada, was considering a
contract extension for two years for the supply of mineral
aggregates (rock, sand, and gravel). The contract had to be
signed within a week.
CITY OF GRANSTON
The City of Granston had an annual budget of $700 million and employed 9,000 people. There had been a steady
population increase over the past two decades. The purchasing department consisted of three support staff, six
buyers, and a manager. City budgets were usually adjusted
annually to cover the cost of inflation.
THE AGGREGATE INDUSTRY
The city purchased about $3 million worth of aggregates
for road construction and repairs and construction projects. The local mineral aggregate sector consisted of three
major extracting and processing companies—Lamoulin,
Richmond, and Atlantic—and several smaller ones.
Lamoulin and Atlantic owned the two dominant concrete
production facilities.
The local aggregate industry was near capacity with
major construction projects underway and increased demand in export markets.
AGGREGATE PURCHASING
A request for quotation had been issued in 2000 for a
three-year agreement for the supply of aggregates, with
prices firm for the first three years. If the parties agreed,
a two-year option was available, with prices being subject
to inflation.
Lamoulin and Richmond were the only two bidders
and each received about half of the total contract with
each bidder quoting for separate components of the total
aggregates contract (see Exhibit 1).
*This case was prepared by Larry Berglund, CPP, MBA, and Collin Ashton, CPP, December 2003.
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Chapter 11
EXHIBIT 1
Description
A Selection
of Mineral
Aggregates
Supplied by
Lamoulin and
Richmond
Screening*
Crushed rock*
Drain rock**
Tailings**
Mulch**
Cost Management 311
Original Price
Current Price
New Price
Request
City Requirement
(metric tons)
9.80
8.80
12.20
8.00
7.10
9.59
8.57
11.88
7.80
6.98
9.78
8.74
12.11
7.95
7.12
3,000
6,500
3,000
75,000
250,000
Prices include delivery and are in $Cdn based on annual estimated requirements.
* Lamoulin
** Richmond
On November 25, both Lamoulin and Richmond sent
notice that they were willing to extend the current threeyear contract to five years. Both wanted an increase of
2 percent to cover the increased cost of doing business. The
suppliers were referring to the Consumer Price Index (CPI)
clause in the agreement for price reviews. This clause allowed the supplier an annual price increase based on the
change in the CPI. According to the city engineers’ department, both suppliers had performed reasonably well during
the past three years. Because of a significant slump in the
local construction industry, both suppliers had voluntarily
lowered their prices by about 3 percent after year one of
the contract.
However, in the past few months the local economy
had shown signs of revival.
TED BARTON
Ted Barton had become purchasing manager for the City
of Granston after having worked in private industry as a
supply manager for several decades. He had been selected
because the city’s administrators wished to integrate supply better into the overall decision processes and to help
search for better value for the taxpayer’s dollars. Shortly
after arriving on his new job, Ted Barton hired a part-time
professional to help him develop better metrics for the
city’s supply function. One of the metrics that concerned
Ted was the city’s price performance. Thus, he developed
a representative basket of 128 city requirements for which
the amount used appeared to vary little from year to year.
For this basket he asked his assistant to develop a price
index, going back three years, starting with a base of 100.0
(see Exhibit 2).
Ted’s assistant also developed a list of key cost indicators based on published indices from a variety of sources
(see Exhibit 3).
THE DECISION
Ted Barton wondered whether any of the metrics he
had recently developed were relevant for his decision
on whether to extend the current mineral aggregates
contract.
Since a significant number of existing city contracts
were also of the multiyear, extendable type, he believed
his actions on the aggregate contract might have a bearing
on how to deal with other requirements. Having only one
week left, he wondered what action to take.
EXHIBIT 2 City of Granston Price Index for a 128-Item Basket of City Requirements
Current Year
Year
3 Years
Ago
2 Years
Ago
1 Year
Ago
Q-1
Q-2
Q-3
Cost of supplies (basket of goods)
100.00
.9199
.9446
.9477
.9410
.9614
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312 Purchasing and Supply Management
EXHIBIT 3 Selected List of Key Cost Indicators
Current Year
Key Indicators
Business prime rate (%)
CPI
Fats & oils
Raw industrials
Textiles
Diesel fuel
Coarse road salt
Natural gas
Copper (US$ per ton)
Metals subindex
joh77899_ch11_288-312.indd 312
3 Years
Ago
2 Years
Ago
1 Year
Ago
Q-1
7.000
111.4
161.82
258.06
236.39
50.36
57.28
4.50
1788.00
236.06
6.875
114.7
165.38
235.55
230.50
52.56
52.91
6.08
1578.00
193.55
4.250
116.2
194.44
231.72
221.41
54.34
52.91
3.82
1559.00
178.92
4.750
121.9
218.99
258.69
234.29
65.04
52.91
6.22
1663.00
201.50
Q-2
5.00
122.0
221.02
260.01
241.01
56.41
52.91
6.00
1641.00
207.09
Q-3
5.00
122.2
236.98
269.91
239.83
58.69
52.91
5.96
1753.00
218.15
6/9/10 10:00 PM
Chapter Twelve
Supplier Selection
Chapter Outline
The Supplier Selection Decision
Decision Trees
Identifying Potential Sources
Information Sources
Standard Information Requests
Additional Supplier Selection Decisions
Single versus Multiple Sourcing
Manufacturer versus Distributor
Geographical Location of Sources
Supplier Size
Supplier Development/Reverse
Marketing
Evaluating Potential Sources
Level 1—Strategic
Level 2—Traditional
Level 3—Current Additional
Ranking Potential Suppliers
Conclusion
Questions for Review and Discussion
References
Cases
12–1 Loren Inc.
12–2 Russel Wisselink
12–3 Kettering Industries Inc.
313
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314 Purchasing and Supply Management
Key Questions for the Supply Decision Maker
Should we
• Use cross-functional sourcing teams to select suppliers?
• Use one or more suppliers?
• Switch from informal to formal supplier evaluation?
How can we
• Reach agreement with internal business partners on evaluation criteria and
weighting?
• Balance financial and nonfinancial factors when selecting suppliers?
• Be sure that we choose the best supplier available?
THE SUPPLIER SELECTION DECISION
“If you choose the right suppliers, all of your supply problems will be solved” is old supply
wisdom. It is at the supplier selection stage that all of the preparation in understanding and
specifying organizational needs comes to fruition. The supply professional’s key challenge
is to match the organization’s needs to what the market can supply. The critical decision is
which supplier(s) to select.
This chapter will first discuss the identification of potential suppliers, where to find
them, and the collection of information. The next topics include whether to select single or
multiple sources, deal directly with manufacturers or go through distributors, and choose
small or large suppliers and domestic or foreign ones. In case no satisfactory source can be
found, supplier development provides an existing alternative to routine supplier selection.
This will be followed by how potential suppliers are evaluated according to the three levels
of criteria described in Chapter 6 and how to rank them.
The decision to place a certain volume of business with a supplier should always
be based on a sound set of criteria. The art of good supply management is to make the
reasoning behind this decision as sound as possible. Traditionally, the analysis of the
supplier’s ability to meet satisfactory quality, quantity, delivery, price/cost, and service
objectives governed this decision. Some of the more important supplier attributes related
to these prime criteria may include past history, facilities and technical strength, financial status, organization and management, reputation, systems, procedural compliance,
communications, labor relations, and location. Obviously, the nature and amount of the
purchase will influence the weighting attached to each objective and hence the evidence
needed to support the decision. For example, for a small order of new circuit boards to
be used by engineers in a new product design, quality and rapid delivery are of greater
significance than price. The supplier should probably be local for ease of communication with the design engineers and have good technical credentials. However, for a large
printed circuit board order for a production run, price would be one key factor, and delivery should be on time, but not necessarily unusually fast. Thus, even on requirements
with identical technical specifications, the weighting of the selection criteria may vary.
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Chapter 12
FIGURE 12–1
Supplier Selection 315
Satisfactory
A Simple OneStage Supplier
Selection
Decision
P
er A
pli
p
Su
1–
p
Unsatisfactory
Su
Satisfactory
ppl
ier
B
q
1–
q
Unsatisfactory
It is this sensitivity to organizational needs that separates the good supply manager from
the average. The one result every supply professional wishes to avoid is unacceptable
supplier performance. This may create costs far out of proportion to the size of the original purchase, upset internal relationships, and strain supplier goodwill and final customer
satisfaction.
Decision Trees
The supplier selection decision can be seen as a decision made under uncertainty and can
be represented by a decision tree. Figure 12–1 shows a very simple one-stage situation with
only two suppliers seriously considered and two possible outcomes. It illustrates, however,
the uncertain environment present in almost every supplier choice and the risk inherent in
the decision. To use decision trees effectively, the supply professional must identify the
options and the criteria for evaluation and assess the probabilities of success and failure.
This simple tree could apply to a special one-time purchase without expectation of followon business for some time to come.
The more normal situation for future repetitive purchases is shown in Figure 12–2.
Whether the chosen source performs well or not for the current purchase under consideration, the future decision about which supplier to deal with next time around may well affect
the present decision. For example, if the business is placed with supplier C and C fails, this
may mean that only A could be considered a reasonable source at the next stage. If having A
as a single source, without alternatives, is not acceptable, choosing C as the supplier at the
first stage does not make any sense.
It is necessary to consider the selection decision as part of a chain of events, rather than
as an isolated instance. This addition of a time frame—past, present, and future—makes
the sourcing decision even more complex. However, as long as the objective of finding and
keeping good sources is clearly kept in mind, the decision can be evaluated in a reasonable
business context.
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316 Purchasing and Supply Management
FIGURE 12–2
Simplified
Three-Stage
Decision Tree
for Supplier
Selection
ss
ce
uc
A
B
C
S
Fa
ilu
A
B
C
Su
pp
lie
rA
re
S
F
S
F
A
B
C
S
F
S
F
S
F
S
F
S
F
S
F
S
F
ss
cce
Su
Supplier B
Fa
ilu
re
rC
lie
pp
Su
ss
cce
Su
Others
Fa
ilu
re
S
A
F
A
A
IDENTIFYING POTENTIAL SOURCES
There are three potential supply options for any new need/requirement of an organization. The make option or doing it in-house may be realistic for some needs but not for
others. These decisions have already been discussed in Chapter 5 under make or buy,
insourcing, and outsourcing. The second option is to acquire the new need from a current
supplier of other requirements. Most supply professionals would be keen to pursue this
option. There is already a record of past performance and communication and logistics
demands are in place.
Assuming past dealings with the current supplier have been satisfactory, the expectation would be that additional business might secure an even better value proposition
on the total set of requirements supplied. Therefore, current good or superior suppliers have a right to expect additional volumes of business as a reward for their performance on current and past business. Both purchaser and supplier stand to benefit from
this understanding.
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Chapter 12
Supplier Selection 317
FIGURE 12–3 Identification of Potential Sources a New Need/Requirement
1. Can We Make In-House?
2. Can a Current Supplier
Meet?
3. Find Potential New
Supplier
No
Yes
Yes
Make
Yes
No
No
Buy
No Supplier
Can Meet
One Supplier
Can Meet
Two or More
Suppliers
Can Meet
Can We
Make
In-House?
One
Supplier
Can Meet
Two or More
Suppliers
Can Meet
Can We Use
Supplier
Development
to Create
Supplier?
Yes
No
No
Can We Redesign/Re-specify so
that Existing or New Supplier
Can Meet?
Rethink
Yes
The third option is to engage in a search for potential suppliers, assuming the first two
options were not satisfactory or the supply professional was anxious to test the market. Figure 12–3 diagrams the three options and the potential outcomes. When no suitable supplier
can be found, the supply professional still has the option of using supplier development
(discussed later in this chapter) or redesign or re-specification to see if a suitable source
can be found or developed. There is a remote chance that, despite all efforts, no solution is
found. Then the supply professional needs to get together with the requisitioner to see if an
alternative or substitute solution can be found.
Information Sources
The identification of potential sources is a key driver of the ultimate success or failure of
the supplier solution effort. Every supply professional is always on the alert for potential
new sources.
Knowledge of sources is therefore a primary qualification for any effective supply manager. Online searches, e-catalogs, and company Web sites are the most common tools used
today. Other sources include trade journals, advertisements, supplier and commodity directories, sales interviews, colleagues, professional contacts, and the supply department’s
own records.
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318 Purchasing and Supply Management
Online Sources
The Internet and the World Wide Web provide a rapidly growing and ever-changing body
of information for supply professionals. The challenge is not just finding information, but
identifying, sorting, analyzing, and using relevant information. The following brief list
contains Web addresses for some sites of interests to supply.
D & B www.dnb.com D&B provides basic company reports online for a fee, and company’s location and products gratis.
Thomas Register www.thomasregister.com The most comprehensive online resource
for finding companies and products manufactured in North America. Services include
online order placement, viewing and downloading millions of computer-aided design
(CAD) drawings, and viewing thousands of online company catalogs and Web sites. It
includes listings for over 173,000 companies in the United States and Canada and over
8,000 online supplier catalogs and Web links.
Worldpages.com www.worldpages.com This is an Internet and Yellow Pages directory company with listings in the United States and Canada and links to more than
350 international directories. It also links to a directory of toll-free (800/888) numbers
in the United States.
World Wide Yellow Pages www.yellow.com/ This is a worldwide listing of companies.
Ziff Davis Media Publications www.zdnet.com This is a resource for information on
e-commerce.
Catalogs
A well-managed purchasing and supply department must have catalogs of the commonly
known sources of supply, covering the most important materials in which a company is
interested. The value of catalogs depends largely on presentation form, accessibility, and
frequency and extent of use. Electronic catalogs (discussed in Chapter 4) are increasingly
used. The advantage of eCatalogs is that both buyers and internal customers have ready
access to them and they can be customized to include the prices and other terms and conditions negotiated by the buyer with the seller. Management of eCatalog content is as serious
an issue as management of hard-copy catalogs. Advances in online catalog management
continue to increase the ease of access and improve the form of presentation.
The accessibility of catalog content is driven by the manner in which it is indexed
and filed, a not-so-simple task even with online catalogs. Catalogs are issued in all sorts
of sizes and formats that make them difficult to handle. Proper indexing of catalogs is
essential. Some companies still use microfilm files and loose-leaf binders with sheets
especially printed for catalog filing; others use a form of card index. Indexing should be
according to suppliers’ names as well as products listed. It should be specific, definite,
and easily understandable. Distributors’ catalogs contain many items from a variety of
manufacturing sources and offer a directory of available commodities within the distributors’ fields. Equipment and machinery catalogs provide information about specifications
and the location of a source of supply for replacement parts as well as new equipment.
Catalogs frequently provide price information, and many supplies and materials are sold
from standard list prices or by quoting discounts only. Catalogs are also used as reference
books by internal customers.
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Chapter 12
Supplier Selection 319
Trade Journals
Trade journals also are a valuable source of information about potential suppliers. The
list of such publications is, of course, very long, and the individual items in it vary
tremendously in value. Yet in every field there are worthwhile trade magazines, and
buyers read extensively those dealing with their own industry and with those industries to which they sell and from which they buy. These journals are utilized in two
ways. The first use is to gain general information from the articles that might suggest
new products and substitute materials as well as information about suppliers and their
personnel. The second use is a consistent perusal of the advertisements to stay current
on offerings.
Trade Directories
Trade directories are another useful source of information. They vary widely in their accuracy
and usefulness, and care must be exercised in their use. Trade registers, or trade directories,
are volumes that list leading manufacturers, their addresses, number of branches, affiliations,
products, and, in some instances, their financial standing or their position in the trade. They
also contain listings of the trade names of articles on the market with names of the manufacturers and classified lists of materials, supplies, equipment, and other items offered for sale,
under each of which is given the name and location of available manufacturing sources of
supply. These registers are organized by commodity, manufacturer, or trade name. Standard
directories include the Thomas Register (www.thomasregister.com), MacRae’s Blue Book
(www.macraesbluebook.com) and Kompass publications (www.kompass.com).
Trade directories of minority- and women-owned business enterprises can assist purchasers with a goal or requirement to increase the percentage of contracts awarded to these
firms. For example, the Central Contractor Registration (www.ccr.gov) simplifies the federal
contracting process by creating an integrated database of small, disadvantaged, 8(a), and
women-owned businesses that want to do business with the government. Searches can be
based on SIC Codes, keywords, location, quality certifications, business type, and ownership
race and gender. Diversity Information Resources (www.diversityinforesources.org) fosters minority economic development through the publication of directories of minority- and
women-owned businesses with access to a database of over 9,800 certified M/WBE suppliers, veteran, service-disabled veteran, and HUBZone suppliers. A number of organizations
also certify businesses as minority- and women-owned, including the Women’s Business
Enterprise National Council (WBENC) (www.wbenc.org); the National Women Business
Owners Corporation (NWBOC) (www.nwboc.org); the National Minority Supplier Development Council (NMSDC) (www.nmsdc.org); and in the public sector, the Office of Small
Disadvantaged Business Utilization (OSDBU) (www.sbu.gov/GC/OSDBU.html).
Sales Representation
Sales representatives may constitute one of the most valuable sources of information
available, with references to sources of supply, types of products, and trade information
generally. One challenge for supply personnel is balancing the need to meet with sales representatives with other responsibilities and time constraints. It is essential to develop good
supplier relations that begin with a friendly, courteous, sympathetic, and frank attitude
toward the supplier’s salesperson. After contact, relevant information should be captured
in a format that can be easily accessed and used effectively. Some organizations develop
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320 Purchasing and Supply Management
routing mechanisms on their Web sites to alleviate the time pressure on buyers and sellers
by providing information about how to do business with the organization and routing callers to the appropriate person.
Supplier and Commodity Databases
Information from any source, if of value, should be captured. For example, an index of
catalogs makes it easy to access a needed catalog. Two common databases are of suppliers and commodities. The supplier database includes information on each active supplier, including locations and contact information, open orders and past orders, supplier
performance scorecards, and other pertinent information that might be of value to future
decisions. Supplier databases may be managed online, in a simple computer file, or in a
card file.
A commodity database classifies material on the basis of the product and includes information related to the sources from which the product has been purchased in the past,
perhaps the price paid, the point of shipment, and a link or cross-reference to the supplier database. Miscellaneous information is also given, such as whether specifications
are called for, whether a contract already exists covering the item, whether competitive
bids are commonly asked for, and other data that may be of importance. Accompanying
files dealing with sources are, of course, those relating to price and other records. Some of
these have already been discussed in earlier chapters, and others will be discussed later.
The information management aspects of enterprise resource planning (ERP) systems and
e-procurement systems are discussed in Chapter 4.
Visits to Suppliers
Some supply managers feel that visits to suppliers are particularly useful when there are
no difficulties to discuss. The supply manager can talk with higher-level executives rather
than confining discussion to someone who happens to be directly responsible for handling
a specific complaint. This helps to cement good relations at all levels of management and
may reveal much about a supplier’s future plans that might not otherwise come to the
buyer’s attention. Such a visitation policy does raise certain problems not found in the
more routine types of visits, such as who should make the visits, how best to get worthwhile information, and the best use of the data once obtained. Experience has indicated
that the best results come from (1) developing, in advance, a general outline of the kinds of
information sought; (2) gathering, in advance, all reasonably available information, both
general and specific, about the company; and (3) preparing a detailed report of the findings
after the visit. When the visits are carefully planned, the direct expense incurred is small
compared with the returns.
Samples
In addition to the usual inquiries and a plant visit, samples of the supplier’s product can be
tested. This requires thinking about the “sample problem.” Frequently a sales representative for a new product urges the buyer to accept a sample for test purposes. This raises
questions about what samples to accept, how to ensure a fair test of those accepted, who
should bear the expense of testing, and whether or not the supplier should be given the
results of the test. (See “Testing and Samples” in Chapter 5.)
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Chapter 12
Supplier Selection 321
Colleagues
Frequently, internal business partners are valuable sources of information about potential
sources of supply. Purchase requisitions may invite the requisitioner to identify potential
sources.
References
Often buyers will include a request for references in the RFQ, RFP, or RFB. To get the
most useful information possible, it is the job of the interviewer to set the parameters for
the interview. First, make sure that the reference is a company of similar size and objectives. Second, talk to people with firsthand knowledge of the supplier’s performance.
Third, ask open-ended questions that allow the reference to describe the performance of
the supplier and the relationship. For example, a new customer might be asked about the
implementation process: “Did it go smoothly? Tell me about a time things weren’t going
according to plan. How did the supplier deal with the problem or change?” A veteran customer might be asked about the supplier’s actions to stay competitive or to continuously
improve: “Tell me about a time when the supplier initiated an improvement that also benefited you (the customer)?” Past customers might be asked about the transition process to
another supplier: “When you switched suppliers, how did the original supplier handle the
transition of information? materials? and so forth?” Potential sources need to be evaluated.
Standard Information Requests
Additional information from the supplier itself is usually sought during the identification of
potential suppliers stage and before supplier selection takes place. As described in Chapter 4, the nature of these communications takes a variety of forms.
The Request for Information (RFI)
The request for information or expression of interest serves several purposes. It signals that
the supply professional has identified a supplier as a potential source of supply. It is also
an opportunity for the supplier to indicate its willingness to enter into a potential business
relationship. Although the content of the RFI may vary considerably from technical data
to interest in receiving an invitation to bid, it is clear to both parties that the RFI does not
commit either party to future business. If the information collection process could result in
significant additional expense for the supplier, it is appropriate for the supply professional
to offer reimbursement of some or all of these costs.
The Request for Quotation (RFQ) or Request for Bid (RFB)
or Invitation to Bid or Tender
These requests represent a serious inquiry of the supplier on a specific requirement or a
variety of requirements. The RFQ and its equivalents ask the supplier to declare at what
price and what terms they are prepared to supply. In the public sector, it is usually assumed that the lowest bidder will be awarded the contract. In the public sector, it is often
an organizational requirement that all requirements exceeding a certain dollar amount be
put out to bid. Bidders are required to submit their bids by a certain deadline and meet all
of the conditions stated in the invitation to bid or tender. Suppliers are invited to attend a
public opening of bids and, thus, each bidder knows exactly what prices have been quoted
by all bidders. After the public opening, public supply professionals usually require some
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322 Purchasing and Supply Management
additional time to examine all bids for compliance with conditions and to deal with possible exceptions. Fair as this process may appear, it is still occasionally abused. Various
bidders may collude to rig prices. A recent example involving road construction contracts
in Montreal had a group of bidders, reported to be Mafia related, deciding on the lowest bid
beforehand and who was allowed to be the lowest bidder. This resulted in an elevation of
construction costs exceeding 10 percent.
In the private sector, there is no public opening of bids and the lowest bid may not be
accepted if, in the opinion of the supply professional, a higher bid represents better value.
Because the preparation of a bid always entails costs for the supplier and may raise expectations, it is deemed ethical practice to invite only those suppliers to bid who have a serious
chance of receiving the business.
In the RFQ, RFB, and Invitation to Bid, the assumption is that requirement specifications are sufficiently descriptive and standard so that multiple suppliers can meet these
requirements. Therefore, the price and terms quoted become the differentiation between
various suppliers.
The Request for Proposal (RFP)
When it is difficult to describe a requirement adequately, or the supply organization lacks
the ability to create an RFQ or the supply professional expects that innovation or creativity in the market might result in a superior solution, the RFP allows more latitude to the
supplier than an RFQ. The RFP permits the supplier to fit the proposal to its strengths. For
the supply professional, comparison of RFPs received is considerably more difficult than
an RFQ evaluation and may involve a lot of judgment. Also, the preparation of an RFP
is often more expensive for the supplier than an RFQ, and the issue of reimbursement
for supplier costs incurred in its preparation needs to be resolved. Moreover, if the RFP
contains proprietary technical or commercial information, protection of confidentiality is
extremely important. Often the RFP is used as the first stage of a two-stage process in
which only certain suppliers are invited to quote on the business or enter into negotiations
for the final round.
ADDITIONAL SUPPLIER SELECTION DECISIONS
The discussion on supplier selection in this chapter has thus far focused on the identification of potential suppliers and information about them. There are, however, additional
decisions that need to be identified and five, in particular, are highlighted here:
1.
2.
3.
4.
5.
Should we use a single source, dual sources, or more than two?
Should we buy from a manufacturer or a distributor?
Where should the supplier be located?
Relative to our organization, should the supplier be small, medium, or large?
If no supplier can be found, should we use supplier development?
Single versus Multiple Sourcing
Should the supply professional choose a single supplier or utilize several? The answer to
this question must be the very unsatisfactory one: “It all depends.”
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Table 12–1 lists the main arguments for placing all orders for a given item with one supplier and Table 12–2 provides the main arguments for multiple sourcing